12/4/08

Ultra ETFs Are Not For Long Term Investing

Historically, the market's tendency is to go up. That's one reason why inverse and ultra inverse ETFs are for short term trades only.

Some may think, however, that since the market tends to go up over the long term, leveraged long ETFs should outperform their regular counterparts. The thinking may be, for example, that if stocks have historically returned 8% per year, a leveraged ETF tracking those same stocks, should return 16%. After this thought comes, "why buy the S&P 500 (SPY) when I can do twice as well with the leveraged S&P 500 (SSO)?" If the S&P goes up x% a year on average over the long term, the leveraged ETF should go up 2x% a year over the same period. Seems like a no brainer.

This kind of thinking would be wrong. Don't be tempted by leveraged ETFs for the long term. Why? Although they go up twice as much as the index they track (there are now leveraged ETFs that go up three times as much), they also go down twice as much when the index falls. As it takes more, percentage wise, to get back to even, leveraged ETFs can lag significantly after their index goes down.

For example, if an index (or an individual stock) falls 25% in value, it has to go up 33.33% to get back to even. Say XYZ is $100 per share. It loses 25%, and is now $75 per share. It needs to gain $25 to get back to $100. While that $25 was 25% of $100, it is 33.33% of $75.

Suppose ABC is a leveraged version of XYZ, and its performance corresponds to twice the daily performance of XYZ. When XYZ falls 25% in value, ABC falls 50%. While XYZ has to gain 33.33% to get back to where it started, ABC has to gain 100%. Say ABC started out at $100 per share. After losing 50%, it's down to $50 per share. To get back to even, it has to gain $50, or 100% of its value.

Now, suppose XYZ, after losing 25%, gains 33.33%. It started out at $100 per share, went to $75, and is now $100 again. ABC, which tracks twice the daily performance of XYZ, will not get back to even. Say it starts out at $100 per share, just like XYZ. When XYZ loses 25%, ABC loses 50%. When XYZ then gains 33.33%, ABC gains 66.66%, which is well below the 100% required to get back to where it was. In this example, ABC starts out at $100 per share, goes to $50 per share, and then goes up to $83.33 a share. While XYZ is unchanged from when it started, the leveraged ABC is down $16.67.

Here's a real life example. The Diamonds Trust (DIA) tracks the Dow Jones Industrial Average (DJIA). Its daily performance is supposed to correspond to the daily performance of the DJIA. So, if the Dow goes up 5%, DIA is supposed to go up 5%. If the Dow goes down 5%, DIA is supposed to go down 5%. The Ultra Dow 30 (DDM) also tracks the DJIA, but its daily performance is supposed to be double that of the index. So, if the Dow goes up 5%, DDM should go up 10%. If the Dow goes down 5%, DDM should go down 10%.

Imagine you bought both at their 52 week highs: As of 12/4/08, DIA's high was $137.90, and DDM's was $96.29. Recent price in this example is as of market close on Wednesday 12/3/08.

DIA
Bought: $137.90
Recent: $86.04
Down: 37.6%
Required gain to get to even: 60.27%

DDM
Bought: $96.29
Recent: $30.84
Down: 67.97%
Required gain to get to even: 212.22%

If the DIA gets back to $137.90 a share, DDM will be somewhere under $66 a share, still down some $30. While the Dow has to gain 60.27% from Wednesday's close for DIA to get back to its 52 week high, DDM won't get back to even until the Dow goes up around 106%!

This sort of thing is a major reason why many investors like to limit their losses to a certain percentage. (William O'Neil, for example, limits his losses to 8%.) The more something falls in value, the harder it is to get back to even. As stock indexes never go straight up, long term investors should avoid leveraged ETFs.

Disclosure: At the time of writing I owned puts on SPY.


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