Unintended Characteristics of Leveraged and Inverse ETFs

The intended characteristics of leveraged and inverse exchange-traded funds (ETF) are obvious. Do they have unintended characteristics that may make them unsuitable for some investors? In their April 2009 paper entitled “The Dynamics of Leveraged and Inverse-Exchange Traded Funds”, Minder Cheng and Ananth Madhavan investigate the dynamics, market impacts, unusual features and investor suitability of leveraged (2x and 3x long exposure) and inverse (-1x, -2x and -3x short exposure) ETFs. Using daily returns for many leveraged and inverse ETFs, they conclude that:

• For a sample of 84 U.S. equity leveraged and inverse funds as of January 2009:
  • Double-leveraged ETFs account for the bulk of interest.
  • Bid-ask spreads are reasonably small, but their economic impact is large because of short holding periods.
  • Average holding periods are very short for 3x and -3x funds (one or two days) and longest for 2x funds (15 days).
  • Institutional holdings are small (under 0.5%).
• The daily re-leveraging of these funds amplifies volatility of the underlying index near the close (re-leveraging of long and short funds is not offsetting). This effect scales with the combined size of relevant leveraged and inverse ETFs, the leverage multiple of these funds and the daily return of the underlying index.
• Gross returns of leveraged and inverse ETFs are path dependent, meaning that different sets of daily returns for the underlying index that result in the same final value for that index may produce substantially different final values for associated leveraged and inverse funds. This path dependence tends to degrade outcomes for investors that buy and hold leveraged and inverse funds, particularly for volatile indexes and for inverse ETFs (see the chart below).
• The drag on returns from the high transaction costs and tax inefficiency of daily re-leveraging reinforces the unsuitability of these ETFS for long-term investors.

The following chart, taken from the paper, compares cumulative returns during September 2008 through early March 2009 for UltraShort Oil & Gas ProShares (DUG) and Ultra Oil & Gas ProShares (DIG), designed to generate -2x and 2x the returns of the Dow Jones U.S. Oil & Gas Index on a daily basis. While these two funds are mirror images over short periods (a few days), during this six-month period both ETFs are down substantially. During other six-month periods, the long-term outcomes for these two ETFs relative to the underlying index may be quite different. This example illustrates the path-dependence risk of leveraged and inverse ETFs for long-term investors.

In summary, leveraged and inverse ETFs bear a potentially material path-dependence penalty, and high transaction costs and tax inefficiency for daily fund re-leveraging, that make them unsuitable as long-term holdings. Daily re-leveraging may have a destabilizing effect on the underlying index near the close.