Another rip-off: Leveraged and inverse ETFs

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(MoneyWatch) The growth of exchange-traded funds has been explosive, and generally for good reason. ETFs can not only be cheaper than their mutual fund counterparts, but also more tax-efficient.

Within the ETF world, there has also been rapid growth in leveraged (often called ultra) funds and inverse (short) funds. The objective of leveraged funds is to provide investors with two or three times the return of an index on a single day. The objective of inverse ETFs is to return -100, -200, or -300 percent of an index on a single day. In order to achieve these objectives, derivates in the form of options, swaps and futures contracts are used.

One concern for investors is if they achieve their objective. Another is that investors shouldn't care about daily returns. That should be the concern of traders and speculators, not investors, who should care about the longer term results.

Gerasimos Rompotis, a doctoral student in business and author of the 2012 paper, "A Survey on Leveraged and Inverse Exchange-Traded Funds," published in the Spring Issue of the Journal of Index Investing, reached the conclusion that "due to the compounding of daily returns, returns of leveraged and inverse ETFs over periods larger than one day will likely differ in amount, and possibly even direction, from the target return for the same period." In short, they don't achieve their objective.

Those buying leveraged and inverse ETFs must understand that the more volatile the market, the less likely it is that investors will receive their expected return. In addition, the longer the holding period of a leveraged ETF, the further away it's likely to get from achieving its target of double or triple the performance of the benchmark index.

Another problem with these products is their expense. While regular ETFs typically have low expense ratios, the average inverse and ultra ETFs were found to have expense ratios of almost 1 percent. In addition, because the market for these ETFs is less liquid than it is for regular ETFs, trading costs are higher. That further compounds the underperformance problem.

Let's take a look at one of the oldest leveraged funds, Rydex's Nova Fund (RYNVX). The fund's first full year of operation was in 1994. For the 18-year period 1994-2011, the S&P 500 Index provided an annualized return of 7.7 percent. Unfortunately, Nova didn't earn anything close to 150 percent of the return of the index. In fact, it earned just 5.7 percent.

Additionally, the increase in exposure to market risk caused the standard deviation of the fund to be 28.9 percent, versus 20.1 percent for the S&P 500. As a result, Rydex Nova investors earned just 74 percent (not 150 percent) of the returns of the S&P 500, yet experienced 44 percent greater volatility.

Leveraged and inverse ETFs are another creation of Wall Street designed to transfer assets from your account to their pockets. There's no reason for an investor to consider them.

Image courtesy of taxbrackets.org

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.