Leveraged ETFs Part 2
Jul 29, 2009
Posted by Jody Eisenman | Filed under Uncategorized
In the last blog posting, I wrote about how ETFs were created and how they work. As promised, we will now explore the leveraged ETFs. A “double” ETF will use leverage (i.e. margin or borrowed money) to double the return of an index. A “triple” ETF will leverage even more to achieve triple the return. Sounds pretty simple, doesn’t it? Here’s the fun part:
Let’s say that an investor is bullish on the Russell 1000 index. Let’s further say that an investor buys a triple ETF to achieve his goals. One might naively think that the ETF would simply triple the return of the index. Unfortunately, this is not true. What the ETF will do is triple the DAILY return. It will almost certainly not do the same for the ANNUAL return. There are 2 reasons for this:
- First of all, every change in the index is magnified in the leverage. For example, if the index drops 10% in a day, the 3x ETF will drop by 30%. At that point, the index is rebalanced due to the leverage. As the index moves up or down, the leveraged ETF must change its’ leveraged position to reflect the movement, which it accomplishes by buying or selling the underlying shares. As they change positions, they increase expenses via transaction costs. This will gradually eat away at the total value of the fund.
- Second of all, the changes in the index are magnified due to leverage and volatility. For example, let’s say the index goes up 10%, down 10%, up 10% and down 10% over a four day period. The returns for owning the index and owning a 3x levered index are quite different:
Day Index Levered ETF
0 100 100
1 110 130
2 99 91
3 108.9 118.3
4 98 82.8
So, after a 4 day (albeit volatile period), the index is down 2%. The leveraged ETF, on the other hand, has gone from 100 to under 83! Generally speaking, the greater the volatility from day to day (meaning swings both up and down), the greater chance of deterioration of the stock price of the leveraged ETF.
Here’s another example in real time. The triple leveraged ETFs that follow the Russell 1000 index trade under the symbols BGU (for the 3x bullish) and BGZ (for the 3x bearish). Each mirrors three times the return of IWD, which is the symbol for the index. At the beginning of the year, IWD was trading at 49.78. It closed yesterday at 50.48, for a total gain of 1.4%. However, a look at the ETFs tells a different story. BGU, which is 3x bullish the index, went from 39.95 to 40.85 during this time period, for a gain of 2.2%. The bearish BGZ, however, went from 53.28 to 28.25, or a loss of 47%. Needless to say, these instruments can be deadly. I will continue with part 3 shortly to explain what the industry is now doing in response to these unanticipated losses.
