Approved for sale by the Securities and Exchange Commission in 2006, leveraged ETFs offer investors the ability to double and more recently triple the gains and losses experienced by many of the same market indices tracked by unleveraged ETFs. They are now some of the most actively traded securities in the United States, and sponsors are listing new funds constantly: in late June, Maryland-based ProFunds Group announced two new funds that give triple long and short exposure to the daily return of the Standard & Poor’s 500. (Massachusetts-based Direxion and Maryland-based Rydex/SGI are the two other major sponsors of leveraged ETFs.)
As leveraged ETFs gain popularity, they have drawn increasing attention from the media and regulators for their extreme volatility–not to mention the unusual features that make them far different from unleveraged ETFs. The Financial Industry Regulatory Authority (FINRA) issued a Regulatory Notice in June reminding firms of the risks posed by leveraged ETFs, the obligation to understand their terms and features, and the need to determine whether they are suitable for each investor’s financial situation.
Leveraged ETFs are designed and managed to provide exposure to the daily return of whatever index or security they track, a feature which is stated plainly in their promotional literature and regulatory filings, but whose full implications are not entirely obvious. Due to the effects of compound leveraging, the “daily return” over a period of more than one day is the cumulative result of a series of daily leveraged returns, and not the leveraged return of the index. That means that, over time, the performance of the leveraged ETF will diverge from the performance of the index the fund tracks. Severe losses can result for investors who fail to appreciate that divergence.
In a fund prospectus, Direxion provides an example of two $100 investments, one in a triple leveraged ETF and another in an unleveraged ETF based on the same index. If the index rises 5% one day, the triple leveraged ETF would rise to $115 and the unleveraged ETF to $105. If the index were to fall by 4.76% on the following day, the unleveraged ETF would return to $100, but the leveraged ETF would decline by 14.28% (triple the 4.76%), or $16.42, leaving an investment worth $98.58.
Over longer periods of time, or greater volatility, the difference is further magnified.