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Joined: 27 Mar 2010
Posts: 192
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 Posted: Fri Jul 30, 2010 11:22 pm Post subject: |
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One of the best articles I've seen written on leveraged etfs... http://seekingalpha.com/article/35789-the-case-against-leveraged-etfs
the important parts are the math when these funds go against you and also the leverage trap.
which is why I say if you trade them catch them on a bottom or a top but stay away on a trendless, or sea saw type price action market. I'll take a look at my sso holding to see if it is breaking these rules - at first blush it appears so if my return is 2x, which it appears to be but I will double check this.
the math:
| Quote: | A widely held misconception about these funds is that they will offer twice the return of the underlying index, which means that if the S&P 500 returns about 10% a year, then the SSO should return 20%. But that’s not true, because these funds only double the daily return, and there’s a big difference between doubling the daily return and doubling the annual return.
What’s the difference? Let’s say that one day the market goes up 10%, and the next day it falls 10%. The two-day loss for the index is 1%, but the loss for the leveraged fund is 4%. Here’s why:
Index: (1 + 10% ) x (1 – 10%) = 1.1 x 0.9 = 0.99, 1% loss
X2 Fund: (1 + 20%) x (1 – 20%) = 1.2 x 0.8 = 0.96, 4% loss
Thus over a two day period, this fund’s losses are 4x the amount of the index, not 2x. This example comes from the ProShares prospectus, and is a clear indication that investors in 2X funds should not expect their investment to provide double the return of the S&P 500 for any period longer than one day. |
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leverage trap:
| Quote: | Constant Leverage Trap
Let’s take a moment to see how a leveraged ETF works. In order to deliver the 2x results that the fund’s investors expect, fund management has to hold equal proportions of debt and equity at all times.
In other words, if there’s $100m invested in the fund, it has to borrow an additional $100m and make a $200m investment in the underlying index. That’s the only way that the fund can provide 2x the underlying daily return of the index.
Of course the fund doesn’t go to the local bank and borrow money every day and then invest it. It uses financial derivatives, such as swaps, options, and futures. But the overall effect is the same.
However, every day the market moves and the assets in the fund either increase or decrease in value, throwing off the leverage ratio because total assets are no longer equal to total debt. By the end of the market day, the fund’s leverage is either too high, or too low, and some kind of corrective action is required to bring it back to 2x.
In order to maintain the target leverage ratio, our fund has to buy or sell millions of dollars worth of shares every day. Not only does this increase expenses, transaction costs, and short-term capital gains taxes, but it’s also just a bad investment strategy.
Whenever the market makes a big move downward, the fund sells shares and reduces its debt level in order to maintain its target leverage ratio. This locks in losses and reduces the afund’s sset base, making it much harder to recover gains in the next market upturn.
Note that this situation is called the Constant Leverage Trap and is a well-known problem in financial modeling. Investment portfolios that try to maintain constant levels of leverage over time perform very poorly in bad market conditions because they sell off large percentages of their assets. It’s similar to a margin maintenance call. |
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