Trading with leveraged and inverse etfs




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Trading with leveraged and inverse etfsTrading with leveraged and inverse ETFs

Click here for Cheng and Madhavan's paper on ETFs. Click here for Avenllaneda and Zhang's paper on ETFs.

Financial markets attract both professional and casual traders because of the variety of investment vehicles available. Among the newer entrants into this mix are leveraged and inverse exchange-traded funds (ETFs). Lately, these products have been the subject of much attention and have attracted considerable assets.

Whereas traditional ETFs attempt to replicate the performance of a stock market index, leveraged (commonly called “ultra”) and inverse ETFs aim to achieve 2x or 3x long exposure, or -1x, -2x, or -3x short exposure. This, and the accessibility of ETFs, creates a vast number of opportunities for investors of all levels. As with all investment vehicles, however, these ETFs are coupled with a large amount of risk. The structure of these funds also creates a number of unintended consequences on the markets and often leads to questions regarding investor suitability.

Since being introduced to the market in 2006, this ETF class has exploded with activity. According to “The Dynamics of Leveraged and Inverse Exchange-Traded Funds” by Minder Cheng and Ananth Madhavan, as of January 2009, 106 leveraged and inverse ETFs have been introduced in the U. S. market alone. The majority, however, of the $22 billion of assets under management (AUM), is in 2x and -2x leveraged products, with only a small percentage of the AUM allocated to the greater leveraged and inverse ETFs.

MORE THAN MEETS THE EYE

The difference between traditional ETFs and leveraged and inverse ETFs goes further than just their exposure to returns. The construction of these investment vehicles also is different.

Regarding traditional ETFs, authorized participants such as institutional investors directly buy and sell creation units (large groups of tens of thousands of shares). These usually are exchanged with a fund manager for an “in-kind” or basket transfer of component stocks. Leveraged and inverse ETFs, which are pre-packaged margin products, are commonly constructed by trading futures contracts or other derivatives and are created and redeemed in cash, rather than the basket transfer. Retail investors get access to these products when they become available on the exchanges.

Several factors account for the attention and attraction of leveraged and inverse ETFs. First, they enable investors, whether they are hedge funds, short-term traders, or retail investors, to trade their convictions, bullish and bearish, without short-sale restrictions commonly imposed on retail accounts. Second, ETFs provide a well-structured product for gaining leverage, while maintaining the convenience of an exchange-listed product and limited liability.

Considering these benefits, some might think that these ETFs are a perfect product for traders and investors alike. The more cynical might instead ask: Whats the catch? What should investors be aware of and take into consideration before investing in ETFs?

UNINTENDED CONSEQUENCES

Despite the ever-increasing volume and assets invested, the features of these funds still are not fully understood by some investors.

By the nature of the structure of these funds, investors have discovered unintended features. Both leveraged and inverse ETFs appear to have a downward bias. Also, though seemingly counterintuitive, these investment vehicles appear to follow a downward trend regardless of their bull or bear structure.

Some have argued that leveraged and inverse ETFs are not suitable for all investors, specifically those with the buy-and-hold methodology because long-run returns can indeed be significantly lower than those of the levered underlying index, especially for more volatile indexes. In the Securities and Exchange Commissions 2009 report “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors,” the regulator warned investors about leveraged ETFs. Indeed, UBS Wealth Management has suspended the trading of these products for their clients.

Plainly written, both leveraged and inverse ETFs appear to have a downward bias. Here, we will search out a model that represents and explains this unintended property.

“Three funds” (above) shows the paths of ETFs based on the Dow Jones U. S. Financials index: the traditional ETF (IYF), the double-leveraged ETF (UYG), and the double-inverse ETF (SKF). Both the leveraged and inverse ETFs underperformed the traditional example.

Before getting to the bottom of the downward drift tendency, its necessary to conduct some confirming analysis. Twenty ETFs were chosen based on highest trading volume and length of available data. They include nine ultra long, six ultra short, and five triple-leveraged ETFs (issued by Direxion Funds). Taking the closing prices since inception and the returns for every 50-day interval, the data shows that only 33% of ETF returns were positive over time, while the remaining 67% had been negative. This suggests that leveraged or inverse ETFs, whether bullish or bearish, decrease in value over time.