Here's why advisers should avoid leveraged ETFs

A look at the performance of some ETFs tracking commodities shows the extreme volatility (not to mention returns)

Jul 25, 2015 @ 10:00 am

By Bloomberg News

You know commodities are having a bad month when 3-times leveraged inverse ETFs start kicking out 4 times the return.

As a reminder, leveraged ETFs aim to provide daily investment results that correspond to 2x or 3x the daily performance of an index through the use of derivatives.

The Direxion Daily Gold Miners Bear 3X Shares, or DUST, is up a whopping 99% in July. Not bad for a few weeks, eh?

Meanwhile its index was "only" down 23%. The 3x inverse of that is 66%, but DUST is up another 33% on top of that. This is due to the fact that leveraged ETFs reset their leverage every day and so experience a compounding effect when the market they track moves in one direction for a long period. So as gold miners fell nearly every day in July — sometimes by quite a lot — this created the perfect situation for DUST.

Gold miners aren't alone as some commodity futures have also been in a downward spiral.

Oil's expedient trip downward in July is why the VelocityShares Daily 3x Inverse Crude ETN, or DWTI, is up 74% month-to-date. That is nearly 4x the inverse of the return on oil futures, which are down 19% in the same period.

This compounding effect in leveraged ETFs is a bit like a full moon. It's pretty when it happens, but it is the exception and not the norm. Normally, the daily resetting can hurt investors over longer holding periods, which is one reason why some U.S. regulators have expressed worries about the products.

JAGGED MOVES

A lot of the time markets move in a jagged manner to get to their destination. This “volatility drag” is why leveraged ETFs' returns typically corrode over time and do not meet their 2x or 3x leverage over the medium and long term.

In fact, this is exactly what has happened to DWTI before July's full moon. While oil futures are down 1% through June, DWTI is down 46% — obviously much more than 3x inverse. This is because the path to that 1% loss for oil was volatile and so it kept resetting its leverage at different points up and down. This situation wreaked havoc on the performance.

The volatility drag has also pummeled DWTI's mirror twin, the VelocityShares Daily 3x Long Crude ETN, or UWTI, which is down big with a 31% loss through June. So basically volatility wiped out both the 3x and -3x. No one is safe.

Despite all this danger, UWTI has taken in $1.3 billion this year in cash — the most of any commodity ETF.

The volatility drag is why some traders will engage in a trade called the “double short” and short both the long and short versions of a set of leveraged ETFs. The only problem is that when the underlying index makes big, consistent moves in one direction for days and weeks, that trade gets destroyed. So anyone who did the double short with DWTI and UWTI in July lost their shirt, even though it worked great up until then.

CRAZY MATH

All this crazy math is why retail investors shouldn't touch these things with a 10-foot pole. They are best left to the professionals since they are the investment-vehicle equivalent of a power tool. DUST, UWTI, and DWTI are very popular with traders as all of them trade over $100 million a day and see daily turnover of between 50% and 100% a day. In contrast, Vanguard ETFs have a daily turnover of just 0.5%.

But even the most sophisticated traders still need to watch out for the devil of daily resetting.

Although on this occasion that devil turned into an angel.

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