Les Jones

“Warning: Leveraged and Inverse ETFs Kill Portfolios”

Monday, August 17th, 2009 | Economics |

Morningstar - Warning: Leveraged and Inverse ETFs Kill Portfolios:

If you think ‘Morningstar is just too conservative,’ then please read any one of these articles from other sources here, here, and here. My intent is not to scare you away from pursuing an actionable investment idea. If you’re hell-bent on using leverage for any period of time longer than a day, you’d be better off using a margin account in almost any real-world scenario. This is not an opinion–it’s a highly likely statistical probability. And interestingly enough, each successive time you bet against the odds, probabilities tend to become mathematical facts. It is my fiduciary duty to inform you as to why these products do not work exactly like their names imply, and I urge everyone in the ETF industry to embark on a similar public awareness campaign.

And the problem is that while a real index tracks said index over any time period, the leveraged and inverse ETFs can only do so on a daily basis. Look what happens:

If you were to repeat 10 consecutive days of up 10% days followed by down 10% days, both of the leveraged funds would end up at $81.54, which is a sizable difference from the $95.10 the index would end at. Repeat this process for only six months, and your ‘investment’ in either of these leveraged funds would stand at only $2.54. Yes, that’s a 97.46% loss. Talk about tracking error.

Now I understand why people say that leveraged and inverse ETFs are intraday plays that shouldn’t be held overnight. Oh, well. This is one of those discoveries that makes me glad I don’t attempt short-term trades.

Tags: etfs, investing

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