Morningstar Advisor - April/May 2009 - 40

Spotlight How Leveraged ETFs Compound the Misery By Paul Justice For long-term holders of these instruments, it’s almost a mathematical certainty that they won’t perform as advertised. Say it’s Dec. 31, 2007, and you’re ready to make a couple of bold market calls for 2008. First, you’re convinced that emerging-markets stocks will face a difficult year. You come across a “double-short” fund, Ultrashort MSCI Emerging Markets ProShares EEV, which aims to deliver twice the inverse of the MSCI Emerging Markets Index. That description fits nicely into your thesis, so you buy a bunch of shares. You’re equally bearish about U.S. real estate. The collapse will finally arrive, you predict. You could just simply short iShares Dow Jones U.S. Real Estate IYR, but why settle for that when you can buy another double-short fund, such as UltraShort Real Estate ProShares SRS. Flash-forward a year later, and you’re sitting there with the most negative of investing emotions: right thesis, wrong execution. In 2008, the MSCI Emerging Markets Index lost 52%. Right call there, but your doubleshort fund, Ultrashort MSCI Emerging Markets ProShares, lost 25%. IShares Dow Jones U.S. Real Estate indeed lost 40%, and shorting it would have given you a savory 40% gain. Instead, UltraShort Real Estate ProShares handed you a 50% loss. If it’s any solace, you’re not alone. Billions of dollars poured into leveraged and inverse exchange-traded funds last year. With labels such as “ultra,” “2X,” “double long,” and “inverse” in their names, these ETFs hold enticing promise for many investors. Problem is these products do not work exactly like their names imply. But dig into their prospectuses, which apparently very few investors are doing, and you’ll find that leveraged ETFs perform exactly the way their creators designed them to work. They just didn’t make the funds for the average investor, and unless you’re a large institution that is going to hold the funds for a day or so, you probably should stay away. Here’s why. Compounding an Error compound a negative return, its impact is always more pronounced than a positive compounding of the same magnitude. Let’s say you make a $100 investment in each of three funds. One is an investment in an index. The other two are leveraged funds that compound daily: One is double-long and the other is double-short. After one day, the index returns 10% and is now worth $110. The double-long adds 20% and is worth $120; the double-inverse loses 20% and ends at $80. On day two, the index loses 10%. That means that the index’s average return [(10% –10%)/2] is zero. The index itself, however, ends at $99 because 10% of $110 is $11, and $110 minus $11 is $99. The fund that promises double the return of the index but compounds daily ends at $96. Remember, the fund started the day at $120. Its return for day two is negative 20% (double the index’s loss), and leaves it with a $24 loss for the day. The double-short fund also ends at $96 because 20% of $80 is $16, and $80 plus $16 is $96. If you were to repeat 10 consecutive days of up-10% days followed by down-10% days, both of the leveraged funds would end at $81.54, which is a sizable difference from the $95.10 the index would end at. Repeat this process for only six months, and your investment in either of the leveraged funds would It’s pretty easy to understand why investors would be attracted to funds that promise double returns. For example, Ultra QQQ ProShares QLD says it will double the Nasdaq’s return. But read the fund’s literature closer. It promises twice the daily return of the index—the key word being “daily.” Daily is not monthly, and it’s definitely not annually. And therein lies the mistake many investors of leveraged ETFs make: They make a compounding assumption that is false. Legend has it that Albert Einstein said that “the most powerful force in the universe is compound interest.” But powerful forces can work both for and against you. Anytime you 40 Morningstar Advisor April/May 2009
Morningstar Advisor - April/May 2009

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