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On ETFs Michael Iachini CFA, CFP®, Director, Investment Manager Research, Charles Schwab Investment Advisory September 14, 2009 Key points
Not all ETFs are so straightforward, though. A rapidly growing segment of the ETF market is made up of leveraged funds—ETFs that promise to provide a multiple of the returns on a given index. There are also many inverse ETFs that aim to go up when the market goes down, and vice versa. While these may sound intriguing, there are reasons for caution. Let's start with leveraged ETFs These funds often have a multiple in their names, such as 2x or 3x, or a descriptor such as "Ultra." If you look up the ETF using Schwab's ETF Screener, you will see it listed with a "Yes" under the "Leveraged Fund" column. This means that the ETF aims to deliver two or three times the return on its stated index. So, a fund that is a "2x S&P 500 Index" ETF is trying to deliver twice the return of the well-known Standard and Poor's 500 Index. If you want to bet on a market rally, these ETFs might seem to let you take extra advantage of a market increase without coming up with extra money to invest. The problem is that if you hold these ETFs for longer than a day, you may not get the multiple of the index return that you typically would expect—and you'll sometimes get something far worse. This is because of the effects of compounding (sometimes called "beta slippage"). Leveraged ETFs aim to deliver their stated multiple of the index return on a daily basis, which means that holding the ETF longer than a day, especially when the index has large ups and downs, can lead to trouble. A leveraged ETF example Consider a hypothetical ETF that promises twice the return of an index. Let's say you buy a share of the ETF for $100 while the underlying index is at 10,000. If the index goes up 10% the next day to 11,000, your ETF should go up 20%, to $120. If the index goes from 11,000 back down to 10,000 the next day, that's a decline of 9.09%, which means that the ETF should go down twice this much, or 18.18%. A decline of 18.18% from the $120 price of the ETF should leave it at $98.18. So even though the index ended up right back where it started, the ETF is down 1.82%! Why does this happen? Well, the ETF rebalances its assets every day so that it will deliver the right multiple of the index's returns on that day. This means that if the index goes up in value, the ETF will have to increase its exposure to the index for the next day in order to get the right multiple, and if the index goes down in value, the ETF will have to decrease its exposure. If the index keeps moving in the same direction every single day, this should result in better-than-expected returns for the longer period. But any reversals in the index direction should leave a leveraged ETF worse off than would be expected based on its multiple. Because of this phenomenon, investors who plan to hold their investment for longer than a day should be cautious when approaching this type of ETF. If you're looking for leveraged exposure over periods longer than a day, consider a margin account or the use of options. However, be aware than any use of leverage will increase your risk exposure and can lead to greater losses, and purchasing leveraged ETFs on margin or buying options on these ETFs will only increase the impact of the compounding issue. How do inverse ETFs compare? Inverse or "short" ETFs have a similar compounding problem. An inverse fund tries to deliver returns that are the opposite of the index's returns. So, if the index goes up 1%, the inverse ETF should go down 1%, and vice versa. These funds are generally found in Morningstar's Bear Market category. Many investors became interested in these "bear market" funds during the market downturn of 2008, hoping to profit in a falling market. Leveraged inverse ETFs also exist, providing exposure equal to some multiple (two or three times) of the opposite of the index return. To see the compounding problem, imagine the same example as before, except with a fund that provides the opposite of the index's daily return. An inverse ETF example If the index falls from 10,000 to 9,000 in one day, a decline of 10%, then an inverse ETF purchased for $100 should rise to $110—an increase of 10%. If the index then climbs from 9,000 back to 10,000 on the next day, this is an increase of 11.11%. The ETF should fall by 11.11%, from $110 down to $97.78. Again, even though the index ended up where it began, the ETF performs worse than expected because of the daily rebalancing. As with "long" leveraged ETFs, these inverse funds should provide better-than-expected returns if the index moves only in one direction, but reversals in direction will work to the detriment of the fund. Inverse and leveraged If an ETF is both inverse and leveraged, the problem only grows. Investors seeking inverse exposure for longer than a day may want to consider options or short selling. However, be aware that both of those strategies have costs and risks of their own, in addition to losing money if the market rises, as it historically has done in the long run. These examples are not merely hypothetical—in markets that move up and down, leveraged and inverse funds have underperformed what a naïve investor might expect. For instance, look at the table below, which shows the returns of the S&P 500® index for the first six months of 2009 and compares it to the returns of a 2x leveraged ETF, an inverse ETF, and a -2x leveraged inverse ETF that are all based on that index. As you can see, the index was up 3.163% for the period. Based on that return, the naïve expectation would be for the leveraged fund to return 6.33%, -1x inverse fund to return -3.16% and -2x inverse fund to return -6.33%. All three funds performed far worse than the naïve expectation due to the problem of compounding (and to a lesser degree due to fund expenses). In fact, all three funds had negative returns, despite the fact that the index itself rose! S&P 500 index return: 3.163%
Be cautious Ultimately, while there may be limited occasions where a leveraged or inverse ETF may be useful for some types of investors, it is extremely important to understand that, for holding periods longer than a day, these funds may not give you the returns you may be expecting. Proceed with extreme caution. Note: At least one provider of leveraged and inverse ETFs is planning to change its methodology so that its ETFs will rebalance monthly, rather than daily. While this may reduce the impact of the compounding issue, it will still be a problem for investors who hold the funds longer than a month. Investors who buy or sell at any time other than the beginning or end of a month will see another twist on the same problem. If you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started. Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800 435-4000. Please read the prospectus carefully before investing. Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Margin Risks:
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. (0709-9105) Return to Top |
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