Funds that attempt to magnify performance long or short with leverage are the ETF industry’s punching bag. Earlier this year, one high profile executive warned they “could blow up” the whole business. Radical views aside, under what circumstances might an advisor use leveraged long/short ETFs? How do these types of funds behave in various market cycles?

Just the Facts Ma’am

A leveraged ETF uses derivatives and debt to magnify the returns of an underlying index. Among the top U.S. providers of leveraged funds are Credit Suisse, Direxion Investments, Deutsche Bank and ProShares. At the end of April, there were 270 leveraged ETFs with around $30 billion in assets, according to Deborah Fuhr, managing partner at ETFGI.

The asset classes covered by leveraged long/short ETFs include commodities, currencies, government bonds, volatility, domestic and international stocks. Despite vocal criticism, these products are transparent, heavily regulated, and have not had a negative impact on financial markets or the ETF industry.

Let’s analyze three different market scenarios and how leveraged long/short ETFs react.

Scenario 1: Market Prices Increase

In Table 1, let’s assume you invest $10,000 in two different ETFs: a triple daily leveraged ETF and a triple daily inverse performing ETF. What happens after the underlying index increases by 5% on a single day? As illustrated, the triple leveraged ETF gained 15% while the triple inverse ETF lost 15%. Both ETFs executed their daily investment goals as they’re supposed to.

Correction: The table above should say $11,500 for the 3X Leveraged ETF Value at End of Day 1.

 

Scenario 2: Market Prices Decrease

Now let’s suppose the index declines by 5% the following day as shown in Table 2. Over the entire two-day period the index has lost 0.25% in value. Yet, the performance for both leveraged ETFs over the same two-day period produces much greater losses of negative 17.25% and negative 2.25%.

As illustrated in Table 2, the performance returns of leveraged ETFs are much more exaggerated compared to the unleveraged benchmark. That should come as no surprise. But keep in mind the performance of leveraged funds over longer time periods is likely to deviate from their underlying benchmarks due to the compounding effect of fund expenses, market volatility and tracking error.

Scenario 3: Market Prices Are Flat

The final scenario is a flat market environment.

Let’s assume the same pattern of performance (up 5% one day followed by down 5% the following day) for 30 consecutive days. What happens at the end of 30 days? Table 3 shows the index lost 3.69%. However, both the leveraged long and leveraged short ETF completed the 30 day period with an identical 28.92% loss.

Table 3 clearly shows that leveraged products don’t perform well during flat market environments. However, in up trending markets as illustrated in Table 1, bull products can produce good results. Likewise, bear ETFs are likely to deliver in a sharp down trending market climate.

Margin Alternative

Certain advisors are using leveraged ETFs in client accounts as an alternative to margin account borrowing. With margin, the investor borrows money from the broker and uses their investments as collateral. The drawback is the client may be forced to sell some or all of their holdings in adverse market conditions. Also, most retirement plans like IRAs have restrictions against margin, which leveraged ETFs get around.

“Using leveraged ETFs I can get 100% of my S&P 500 coverage by only using 50% of the cash and then I have plenty of cash to put on my other positions,” said Frank R. Stanley, president of Global Wealth Analytics in Encinitas, California. “I also don’t have to wait three days for settlement upon selling one fund and buying the other depending on use of funds and ETF.”

Ultimately, the use of leverage is mostly hinged on allowing a manager to have cash on hand instead of tying it up in a non-leveraged ETF or other assets. “You can’t add satellite positions if your one-to-one ETFs use up 100% of cash and doesn’t allow you to overlay other positions,” adds Stanley.

Determining Suitability

Three key factors that advisors should weigh before deciding to invest in leveraged long/short ETFs are the client’s risk tolerance, investment time horizon and overall investment goals. In each instance, the products should be compatible with the client’s needs.

For actively managed client portfolios, trading or hedging with these types of ETFs may be a good fit. This is especially true if the advisor—with the client’s approval—has carved out a portion of a client’s investment portfolio to make tactical investment decisions. This may involve going long certain assets with leverage or shorting.

Some of these tactical trades may come with an abbreviated holding period, in which case using a leveraged ETF could be an appropriate choice. Remember: The investment objective of leveraged long/short ETFs is to achieve short-term investment results that correspond to the daily inverse or daily magnified performance of a benchmark, so don’t expect something else.

Summary

Generally, leveraged long/short ETFs do well at tracking their underlying benchmarks when markets are trending in a certain direction for one day to up to several days. However, during volatile times or range-bound markets the performance of leveraged ETFs can stray significantly from underlying indexes, especially over longer periods of time.

Freeing up cash to invest elsewhere is a big advantage that leveraged ETFs offer. “If you’re looking to be efficient with your use of capital but get magnified exposure to a particular asset class in either a bull or bear ETF, you’re able to do that, said Andy O’Rourke, managing director at Direxion Investments.

Talk with clients and examine their situation before determining if leveraged long/short ETFs are right or wrong.