Triple-leveraged ETFs not for the faint of heart

Buyer beware: These high-risk ETFs are full of surprises

Larry MacDonald
Globe Investor Magazine, March 10, 2009

If you like bungee jumping from swaying towers, chicken wings soaked in suicide sauce, or the sound of spinning roulette wheels, exchange-traded funds (ETFs) with triple leverage might be for you.

By using swaps, forward contracts and other derivatives, they return three times the change in a market index -- either in a direct relationship or inverse. One of them lost 30 per cent of its value in a day, then went up 100 per cent over the next five, after which it lost nearly 50 per cent in a day.

Plenty of investors seem to be drawn to the roller-coaster ride: Average daily trading volumes have jumped into the millions for the eight triple-leveraged ETFs introduced in mid-November by Direxion Shares - with the Financial Bull ETF leading the way at 33.6 million units. The eight triple-leveraged ETFs introduced in December and January still appear to be gaining footing.

Still, the reviews to date haven't been pretty for the most part. Paul Kedrosky, editor of business blog Infectious Greed, labelled them "basement financial bomb-building kits." His concern is that many investors could end up seriously damaging their portfolios unless they fully understand the nature of the beasts.

James Cramer, host of CNBC's Mad Money, has called them weapons of mass destruction because he believes they are exacerbating volatility in stock markets. Mr. Cramer wants the Securities and Exchange Commission to ban them.

Three times the change? Not quite

Despite their name, these ETFs generally fail to track three times their underlying indexes over extended periods. What the ETFs promise are triple returns on the daily movements of the indexes, not weekly, monthly, annual, or other longer periods. This divergence can be seen in trading to date. Take, for example, the change in the Large Cap Bull ETF.

As illustrated in this chart, the ETF was down 5 per cent while the underlying index was up 1 per cent. Also, on Dec. 4, the ETF was up only 5 per cent when the index was up 4 per cent .

Change in Large Cap Bull 3x (BGU), 3x Bear (BGZ) ETFs and Russell 1000 Index (RUI)


This is because the fund has to rebalance the swaps and other derivatives daily to maintain the leverage factor of three. When the market goes up on a given day, more derivatives need to be bought to maintain the triple leverage; if the market goes down, some derivatives need to be sold to maintain the ratio. Altering the number of derivatives changes the amount of principal invested and, in turn, the compounding effect over time.

Compounding

As another example, suppose the index goes up 10 per cent on the second day and down 10 per cent the next. To replicate these daily changes, the 3x ETF rises from 100 to 130 on the second day and falls to 91 on the third. The cumulative change in the index over the three days is -1 per cent (99/100). The cumulative change in the 3x ETF, on the other hand, is -9 per cent (91/100).

Compounding "causes the long-term returns of leveraged funds to deviate from their expected goals," says ETF expert, Matthew Hougan, of IndexUniverse.com. "Over a week, month or year, they won't come close to that 300 per cent return, because compounding (particularly in volatile markets) will have an enormous impact on the results." When markets are volatile -- as they are now -- triple-leveraged ETFs would appear to be mainly for risk-tolerant day traders.

Counterparty risk

The use of over-the-counter derivatives means that leveraged ETFs take on counterparty risk -- the possibility that the party on the other end of the derivative contract cannot follow through on its promise to pay. But this is not a catastrophic risk because no principal is at stake. The loss is confined to the gain accumulated in the derivative -- so the hit comes just as a lower return.

More triple-leveraged ETFs in the pipeline

Direxion Shares has asked the Securities Exchange Commission for permission to launch another two dozen triple-leveraged ETFs. They will cover geographic regions such as China and major indexes such as the NASDAQ 100. The website IndexUniverse.com has the complete list.

Special to The Globe and Mail