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How Short and Leveraged ETFs Work

January 8th at 1:00pm by Tom Lydon



http://www.etftrends.com/2009/01/how-short-leveraged-etfs-work/

Short, Leveraged ETFsShort and leveraged exchange traded funds (ETFs) were the subject of much discussion in 2008, owing in large part to record market volatility. But sometimes their inner workings can be a bit of a mystery to investors.

These types of funds allow investors the opportunity to hedge their portfolios, even in down markets, making them especially attractive in tough years. They were among the top performers in 2008, with 19 of the top 20 being of the short and ultra short variety. Their popularity last year made them the subject of derision, most notably by Jim Cramer.

But leveraged ETFs are a different animal than your average fund. When it comes to them, however, it’s caveat emptor. No matter where you choose to invest your money, it’s always wise to be aware of both the pros and cons. Not all products are right for all investors. These funds certainly do have applications for investors who are looking to hedge positions or make money in down markets on a short-term basis. They aren’t meant for a buy-and-hold strategy.

Leveraged ETFs have long been noted for their higher volatility, since they maximize market movements in either direction. In a year such as the one we just saw, the volatility even in some plain vanilla ETFs was stunning – never mind those that magnified the market’s movements by double or triple.

However, long and short ETFs can have tracking error. On a day-to-day basis, the performance isn’t 100% perfect, but it’s fairly close. However, over the long-term, there can be bigger differences between long ETFs and their short counterparts.

Matthew D. McCall for Seeking Alpha notes it this way:

* Assume the S&P gains 4% on Monday. The ProShares UltraShort S&P 500 (SDS) will fall 8%.
* On Tuesday, the S&P falls 3.8% to end the two-day period flat. SDS will rise by 7.6%, leaving it down 1% after the same two-day period.

So, even though the S&P is flat in this scenario, the SDS will have a 1% loss in just two trading days. The phenomenon is that when you fall by a certain percentage, it takes a bigger gain to get back even. A loss of 50% will require a 100% gain to get back even. Over time, 1% here and there adds up.

In short, on any given day, these funds do what they’re supposed to, but over time internal compounding can have a positive or negative effect. To hear more about short and leveraged ETFs, listen to our most recent podcast.

A long fund, such as the Ultra S&P 500, seeks to double the returns of the S&P 500. That means when the index goes up, your returns will double that.

If a fund looking to double the S&P has $100, then the fund will contain tools to give it roughly $200 exposure to the S&P.

And that exposure is gotten in much the same way: buying baskets of stocks that might give dollar-for-dollar exposure, along with futures contracts and swaps, which are inherently leveraged. This means that if you put down $1, you will get $1of exposure.

A short fund, such as the shorts or two beta, seek to provide either the opposite of the index, or twice the opposite. They can be a way to capitalize when the markets are heading south.

Shorts work in a similar way, with one key difference: no long positions are bought. Short funds also don’t short stocks. Instead, they primarily short futures contracts and swap agreements.

As it’s been said before, just be sure to use these products with caution – as much as they have potential to generate super-sized returns, they can leave a super-sized ding in your portfolio, too.

For more information on leveraged funds, watch this video over that The Wall Street


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HOW LEVERAGED ETFS WORK?

A leveraged etf offers the investor a simple way to buy a broad index or sector with double or triple the exposure of the underlying index. Similar to their single leveraged counterparts, leveraged etfs can trade specific segments or slices of the marketplace. For example, the UYG Ultra Proshares allow investors to buy a financial etf which doubles the returns of the actual Dow Jones U.S. Financials Index.

A leveraged etf will allow investors to put a leveraged bet on either side of the market, long or short. This means that you can buy a 2x bearish etf which will increase when the market heads south; these are commonly referred to as inverse leveraged etfs. Conversely, you could buy a 2x bullish fund which will increase when the market moves higher. You may ask the question, “why would anyone short a leveraged etf if they could go long the bearish fund?”. In some cases, the bearish etf will be very illiquid and have very wide bid/ask spreads; therefore, some traders will short the bullish version of the etf in an attempt to gain the same exposure of the bearish fund.

Leveraged etfs don’t require the use of margin, it is inherently built into the security; however, for those of you using margin to purchase these securities, you will actually get 4x to 6x leverage depending on the security you purchase. Proshares and Rydex are the two leaders within the double leveraged etf space. Direxion is currently the only ETF firm which offers 3x leverage; however, Proshares has announced its intent to launch 94 of their own 3x ETFs.
Where can I buy a Leveraged ETF?

Leveraged etfs trade on NYSE Arca and Amex; however, you will find that most of them predominately trade on the Amex. In recent months however; NYSE Arca has started taking a more active approach to listing these securities.
WHO TRADES LEVERAGED ETFS?

You will see many day traders using double leveraged etfs to play the short term swings of a market. This way, small moves in the index can be glorified into larger moves and the trader does not need to employ the use of margin. These instruments are particularly useful for gaining exposure to the bearish side of the market in a rollover IRA or traditional IRA, where margin and short selling are restricted.
DISADVANTAGES/DRAWBACKS OF LEVERAGED ETFS

There are a few negatives aspects of a leveraged etf that we should cover here. Before you dive in, investors should understand how leveraged etfs work. These trading vehicles are great for active traders who are looking to scalp directional trades in the market. However, longer term investors need to understand that leveraged etfs are not suited for them. Simple math will illustrate how they can erode your portfolio value over the long run. Have you ever scratched your head, wondering why the market is up 10% over the last 3 months and your leveraged etf is actually flat to even down?

Let’s take a look at an example by comparing the returns of the S&P 500 to the SSO (double leveraged S&P 500 etf). As of May 15, 2009, the S&P 500 is down approximately 2.3% YTD. Therefore, we would expect the double leveraged SSO to be down 4.6%, right? Wrong! The SSO is actually down 7.6% in that same time period with a loss 3% greater than you would expect.

Market volatility will destroy the longer term value of a leveraged etf. Let’s use our example from above to illustrate this point.

On December 31, 2008, the S&P 500 closed at 903.25. On March 6, 2009, the S&P closed at 683 for a loss of 24.4%. During this same period, the SSO lost 43.4%. Now, to get back to breakeven, the S&P needs to gain 32%. The SSO, on the other hand, will need to gain 77%, which is far more than double the loss of the index.

The numbers are never exact since an ETF is traded like any other stock; with an auction market determining the value of the fund. They are unlike mutual funds which price nightly to reflect changes in the underlying fund components.
Liquidity

Leverage ETFs also tend to have a lack of liquidity compared to their single leveraged ETF counterparts. There just isn't a large market for these instruments and it will become risky for those of you who trade larger sizes and need to either get out with the least amount of slippage or hedge the position using options contracts. The spreads on some of the less liquid double leveraged etfs can be a couple dollars at times and this makes it nearly impossible to trade these with any consistency.
Expense Ratios

Secondly, expense ratios for a leveraged ETF are higher and making it very difficult for longer term investors to profit the way they should when the underlying index moves.
Position Mismatches

Thirdly, you need to be careful to check into the underlying positions that are held by the leveraged ETF. This is the case especially for leveraged sector funds which may or may not have all the stocks that you expected them to have. Some of the ETFs may have excluded key components of a sector.
LIST OF LEVERAGED ETFS - LONG AND SHORT

To get the most updated leveraged etf list from both ProShares and Rydex, you can use the following links:
Double Leverage Funds

Proshares:
Long Funds
Short Funds

Rydex:
Long & Short Funds
Triple Leverage Funds

Direxion:
Long & Short Funds

http://www.mysmp.com/stocks/leveraged-etfs.html