Jim Cramer has long been calling for a ban of the leveraged short ETFs and in a Reuters article SEC chairwoman Mary Schapiro said she’s concerned with the lack of oversight with leveraged short ETFs saying the funds have been “scrutinized inadequately”. She said that staff would be added to deal with the enormous complexity of some of the more elaborate ETFs that have hit the market recently which include commodity ETFs.
Critics such as Cramer contend that ETF’s that let investors short sectors with leverage are dangerous for individuals and the overall market and that some savvy investors are using them to force segments of the market such as financials to fall faster than they would if just based on fundamentals alone. There are also concerns that many of these ETFs don’t perform as advertised. This might explain why Direxion recently made changes to the naming of their ETFs to reflect the returns based on daily performance. Many articles have been written recently highlighting the under performance of the leveraged ETFs over longer time periods to which I’ll say again… know what you’re trading at all times. The leveraged ETFs are better suited to short term hedging and momentum plays.
Would someone please explain, in simple English, why the leveraged ETFs under perform over longer periods of time. If they are constructed to “match” the ups and downs of their stocks, why does this price match happen?
It’s because of two things: volatility and momentum.
A high volatility has a depressing effect on both short and long leveraged ETF’s. This can be massive if volatility is very high. Likewise a relatively low volatility raises both short and long leveraged ETF’s. I believe the point at which the net effect is about zero for the S&P 500 is when its volatility index is about 20 (don’t know about other indexes).
(http://finance.yahoo.com/q?s=^vix)
About momentum: apparently if a (short or long) leveraged ETF is making profit (its stock price is going up), the leverage is increased and vice versa.
Thus: best case scenario for (short and long) leveraged ETF’s: a steady increase of its price under low volatility. Worst case scenario: a non-directional market with high volatility.
A leveraged ETF can’t match performance of an unlevered fund because it implicitly pays for the cost of borrowing in creating leverage.
Also, ETFs on commodities will either overperform or underperform depending on whether the underlying commodity futures market is in backwardation (downward sloping futures price curve) or cantango (upward sloping price curve).
Assuming a long commodity ETF needs to maintain a hedge that reflects the goals of the long commodity fund, the ETF uses futures (or swaps whose pricing depends on futures) to place a long position on the commodities. To maintain the long hedge, the ETF rolls forward into the next month each month by selling the front month futures contracts to buy next month futures. if the curve is upward sloping and the fund is long the commodity, this means the fund sells low to buy high every month (or every couple of months depending on the contract maturities they trade)