From the May 2007 issue of Wealth Manager Web • Subscribe!

Leveraged Tricks

Does this sound familiar? You have a prospect who has worked in the technology sector for 25 years. The equity portfolio she wants you to manage is 70 percent tech. You don't hate tech, but you don't love it to the point of devoting 70 percent of a portfolio to it. So you want to reduce the tech exposure. But the client doesn't want you to sell her tech stocks because she'll get killed with taxes. And she doesn't want you to sell short or buy puts to hedge the positions. She's heard that selling short and playing in the options markets are, well, risky. (Never mind that having 70 percent of a stock portfolio in tech is probably a tad risky as well.) What do you do?

Sure, you could refuse to take the portfolio. But it's a $3 million account. That's $30,000 in annual fees, which would go a long way toward paying some of those increased compliance costs. And while everyone says that "some business is not worth taking," that's usually code for refusing small accounts--not $3 million portfolios. Still, you know that your ability to add value is going to be severely limited by the client's restrictions.

Fortunately, advisors have new weapons at their disposal to help make the decision easier.

One of the more intriguing developments in the exchange-traded fund world is the emergence of "leveraged" and "inverse" ETFs. These ETFs, which utilize futures, options and other derivatives, give advisors an easy and efficient way to simulate strategies like hedging and short-selling.

The market leader in leveraged and inverse ETFs is ProShares. The company has been offering similar strategies in the open-end mutual fund space for nearly a decade with its ProFunds brand and has introduced similar strategies to the ETF marketplace. The firm now offers 52 leveraged and inverse ETFs covering a host of indices and sectors. The funds, which have garnered more than $3 billion in less than a year, come in three flavors:

o Short: These ETFs seek daily investment results (before fees and expenses) that correspond to the inverse of the daily performance of the underlying index or sector. For example, ProShares Short SmallCap 600 (SBB) aims to provide the inverse performance of the S&P SmallCap 600 Index. If the index is down 2 percent in a day, ProShares Short SmallCap 600 expects to be up around 2 percent. Obviously, this leverage works in both directions. If the S&P 600 is up 2 percent, expect Short SmallCap 600 ETF to be down about 2 percent.

o UltraShort: These ETFs take shorting to another level by seeking daily investment returns that correspond to twice the inverse of the daily performance of the underlying market or sector index. For example, if the S&P 600 falls 2 percent in a day, ProShares UltraShort SmallCap 600 (SDD) expects to be up around 4 percent, and vice versa.

o Ultra: These ETFs leverage an index's returns by 200 percent. For example, ProShares Ultra SmallCap 600 (SAA) is expected to provide twice the daily return of the underlying index. Thus, if the S&P 600 increases 2 percent, the Ultra shares are expected to increase roughly 4 percent. And if the index declines 2 percent, the Ultra shares are expected to decline 4 percent.

While ProShares currently dominates the market for leveraged and inverse ETFs, the competition is coming. Rydex reportedly has 96 leveraged and inverse funds in registration. And other ETF sponsors have adapted the "inverse" idea to other products. For example, PowerShares DB US Dollar Bearish (UDN) and Claymore MACROshares Oil Down (DCR) provide ways to make inverse bets on the dollar and oil prices.

While leveraged and inverse ETFs may not be suitable for every client, plenty of scenarios exist where these ETFs may be extremely useful in managing client portfolios:

An easy way to short the market or sectors. Perhaps one of your indicators is screaming a sell signal on a stock, sector or market index. However, short-selling may be impractical for a variety of reasons. First, selling short is not permitted in IRAs, which is too bad since you manage a lot of IRAs. Second, you may have to persuade clients to open a margin account in order to sell short. Third, you have to explain the risks of short-selling, which include (in theory, anyway) the potential for unlimited losses since there is no cap on how high a stock can rise. Still, you would love a way to capitalize on those few times when you want to play the short side of the market. Inverse ETFs, which rise when the underlying index falls, offer a way to simulate short-selling without some of the hassles. You don't need a margin account to buy inverse ETFs. Moreover, inverse ETFs allow you to simulate shorting while still capping your risk to the amount of your investment in the ETF. And inverse ETFs may be bought in IRAs, thus bringing some hedging possibilities to what often is the client's largest asset.

A tool for tax-efficient investing. Inverse ETFs provide a tool for managing taxes. Let's return to the example at the beginning of this article. The prospect does not want you to sell her tech stocks since she has huge unrealized gains. One way to avoid the tax issue, yet hedge the portfolio from a downturn in the tech sector, would be to purchase ProShares UltraShort Technology (REW). This ETF returns twice the inverse daily return of the Dow Jones U.S. Technology Index.

Another way to use inverse ETFs as a tax hedge is by lengthening holding periods. For example, let's say you want to take profits in a client's rather large position in a semiconductor stock that he's held for just 10 months. Your client is in the top tax bracket. You know that by holding out for another two months, you can convert the big gain to long-term and sharply reduce the tax bite. However, you are also worried about losing your gains over the next two months. One strategy would be to buy the ProShares UltraShort Semiconductors (SSG). In this way, you have some protection if the stock declines during your two-month waiting period. To be sure, such tax and hedging strategies are not free. Still, the inverse ETFs do expand your toolbox when dealing with client taxes or hedging needs.

Better management of client inflows/outflows. If your business is like mine, it's not unusual to receive client assets in chunks. For example, you may have a client who is committing $1 million, but the money is coming in two installments--$500,000 today and $500,000 one month from now. My firm likes to buy individual stocks, but I'm not real excited about buying to my model with the initial $500,000 and buying the same stocks again--and incurring a fresh set of trading fees--a month from now. And I don't want to buy just half the model positions with the initial $500,000; that's too concentrated a portfolio to run for one month. However, I'm also not excited about holding $500,000 in cash while I wait for the other $500,000. One strategy would be to take the initial $500,000 investment and give the client immediate and full market exposure by buying the ProShares Ultra S&P 500 (SSO). This ETF provides twice the daily return of the underlying index. In effect, you've leveraged your $500,000 investment into a $1 million exposure to the S&P 500. And you have done so without taking on margin debt. Once the second installment hits, you can cut or close out your position in the ETF and create your $1 million portfolio of individual stocks.

Of course, as is the case with any investment, investors need to be aware of several factors when considering leveraged and inverse ETFs. Perhaps the most important point to understand--and the source of most of the confusion surrounding leveraged and inverse ETFs--is this: Don't expect daily correlations to match up with longer time periods.

Remember that leveraged and inverse ETFs purport to provide correlated returns to the underlying index on a daily basis. However, because of the nature of daily compounding, returns over longer periods can diverge from these correlations--sometimes significantly.

Here's a simple example: Let's say you buy a ProShares ETF that attempts to return twice the inverse of the underlying index on a daily basis. On day one, the index jumps from 100 to 110, or 10 percent. The ProShares ETF would thus decline 20 percent ($50 to $40). Now, on day two, the index declines 10 percent, bringing the index value to 99. The ETF, because it returns twice the inverse of the index, would rise 20 percent for the day, bringing the ETF value to 48. Now, after two days, the index is down 1 percent while the ETF is down 4 percent. Thus, while the ProShares fund, on a daily basis, did what it said it would do, when you look at the entire period, the ETF actually did worse than the underlying index.

At this point none of the ProShares ETFs is a year old. However, by examining the longer track records of the sister ProFunds mutual funds, you can get a glimpse of how this divergence can be accentuated over time. For example, the ProFunds UltraBull (ULPIX) mutual fund seeks to provide twice the daily return of the S&P 500 Index. Interestingly, the S&P 500's three-year annualized return is around 9 percent. The UltraBull's three-year annualized return is only 2.5 percent better, not double the 9 percent return of the underlying index.

To see how performance can diverge over shorter time periods, check out the table below left showing the year-to-date performance for a few ProShares ETFs and their underlying indices.

And compounding of daily returns is only one source of "tracking error" between the underlying index and ETF. Proshares charges some of the highest fees among ETFs, with expense ratios of 0.95 percent. And ProShares is waiving expenses of 0.40 percent or more in some of its ETFs.

Another potential drag comes from bid-ask spreads. I recently looked at the bid-ask spreads of several of the ProShares sector UltraShort funds. What I found was that it was not uncommon to see spreads of $0.17 to $0.25. In many cases, these spreads were more than double the bid-ask spreads of ETFs that mirror the same index. For example, the bid-ask spread in mid-March for ProShares UltraShort Consumer Services (SCC) fund (which tracks the Dow Jones U.S. Consumer Services index) was $0.20--more than three times the bid-ask spread on the iShares Dow Jones U.S. Consumer Services (IYC) ETF.

Taxes represent yet another drag on performance. While ETFs as a group are tax-friendly investments, investors in leveraged ETFs are vulnerable to short-term capital-gains distributions. For example, ProShares Ultra QQQ (QLD) paid out $5.31 per share in capital-gains distributions ($5.14 of it short-term gains) in 2006. That equated to approximately 6 percent of the fund's net asset value. ProShares Ultra Dow30 (DDM) paid out $6.14 per share in capital-gains distributions ($5.96 in short-term gains), or roughly 7 percent of the fund's net asset value.

Thus, if you use leveraged funds, make sure you discuss the possibility of capital-gains distributions with your clients so there are no surprises come tax time.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

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