Levered ETFs: Heads you lose, tails you lose more?

Heads or tails?
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COMMENTARY Do you think stocks will move up or down this year? I've noted the poor track record of 2011 forecasts by so-called market strategists, but shouldn't those who get it right be rewarded? Some of my clients have come to me with ProShares Ultra Pro ETFs (exchange-traded funds) that borrow to get three times the exposure of a position. These are known as levered ETFs. And though I've argued that this is merely a gambling strategy, it may be an even worse gamble than I thought.

Let's look at the 2011 performance of two ProShares funds -- the ProShares UltraPro S&P 500 (UPRO) and the ProShares UltraPro Short S&P500 (SPXU) funds. Each has an annual expense ratio of 0.95 percent. It may be natural to think that, if the S&P 500 total return was zero, both would return a loss of 0.95 percent annually. Well, in 2011, the total return of the S&P 500, including dividends, was up 2.11 percent. So we might expect the UPRO 3x long fund to gain a bit and the SPXU 3x short fund to lose a bit. The actual 2011 performance was as follows, according to Morningstar:

-- UPRO 3x long fund down 11.88 percent

-- SPXU 3x short fund down 32.35 percent

Why this happened

In deconstructing this head-scratcher, one might think the funds didn't do what they were designed to do, but in fact they did. Scott Burns, Morningstar director of ETF research, said these two funds did a pretty good job of executing their stated strategy of delivering "3x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next." The key words, which are actually highlighted in bold, on the ProShares website are "for a single day."

To put it another way, each of the levered ProShares funds invests with a horizon of a single day. Compounding can cause a loss no matter which side of the bet you are taking. In certain circumstances, the sum of the long and short funds could be positive. Burns told me he didn't believe these funds were appropriate for investors with time horizons of more than a few days. The promise of a 3x return is only good for one day.

The second reason for the performance is that these funds have costs beyond the stated expense ratio. There are costs to build the daily derivatives to deliver the stated performance each day.

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What did ProShares have to say? "We have heard from many investors and advisors who have successfully used geared ETFs to help manage risk," said Steve Cohen, managing director of ProShares. He added, "It's important for investors to understand that the math of compounding can cause returns over time to be lower than the daily objective in volatile periods, or higher than the daily objective in trending periods. Investors who seek to increase the likelihood of achieving returns close to the daily objective should consider a rebalancing strategy."

My advice

If your advisor has you in ProShares or any other brand of levered investments like these, it better be part of an extremely active trading strategy (which I also recommend against). What did I tell those people who came to me with ultra-short levered funds? I suggested that their odds of winning would be better if they took the money to Las Vegas. I think it would be more fun as well.

Matt Hogan, president of EFT Analytics, said, "The 3X funds are sharp tools, and if you're careless with them you'll get hurt. There is no such thing as investing in these products. They are trading tools, pure and simple, and this shows that better than anything else."

ProShares may bill itself, and even trademarked the term, "the alternative ETF company," but it ends up being more active and expensive than many active funds. Jack Bogle brought indexing to the public to capture nearly all of the return of the markets. Stick to broad index funds with ultra low costs.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.