Warning: Leveraged and Inverse ETFs Kill Portfolios

I recently returned from the 'Inside ETFs' conference, which is widely attended by ETF industry insiders and financial advisors, and I was shocked to learn how many people have a misconception as to how these funds work. And this sampling was not of novice day traders--these are professionals and financial advisors. They research a product before they dispense advice or buy something.

If you think 'Morningstar is just too conservative,' then please read any one of these articles from other sources here, here, and here. My intent is not to scare you away from pursuing an actionable investment idea. If you're hell-bent on using leverage for any period of time longer than a day, you'd be better off using a margin account in almost any real-world scenario. This is not an opinion--it's a highly likely statistical probability. And interestingly enough, each successive time you bet against the odds, probabilities tend to become mathematical facts. It is my fiduciary duty to inform you as to why these products do not work exactly like their names imply, and I urge everyone in the ETF industry to embark on a similar public awareness campaign.

Today, there are more than 845 ETFs on the market. Some are great products that have greatly enhanced the investor experience. Others are betting mechanisms that can scorch your portfolio in just a few days. When we put together an ETF research report, and we currently cover more than 300 ETFs that represent over 94% of the market's total assets, our intent is to let you know how to use these products properly. We start with a suitability assessment, or our view as to which type of investor should use each specific product and how. With virtually every leveraged and inverse fund, I can tell you that they are appropriate only for less than 1% of the investing community. Considering that these funds have attracted billions of dollars over the past year alone, it's pretty obvious that too many people are using these incorrectly.

Check Out these Returns (or Lack Thereof)
Pointing out that leveraged ETFs are working as they were intended would hardly be shocking news if the returns these funds were producing were not so, well, shocking.

Here are three funds that track the same MSCI Emerging Markets Index:  Vanguard Emerging Markets Stock ETF ,  Short MSCI Emerging Markets ProShares and  UltraShort MSCI Emerging Markets ProShares .

To summarize, one fund tracks the index and lost 52% last year, one aims to deliver the inverse of the index and gained 20%, and the last aims to deliver twice the inverse of the index and lost 25%. Did you follow me there? While the fund that held the stocks lost 52%, the one that aimed to deliver twice the inverse also lost a substantial 25%. And the funds worked like they were supposed to. And this was one of the better performing examples. At least the inverse fund, which is meant to be used only for a single day, produced a positive return, as expected. Check out this next example.

If you were prescient enough to predict the collapse of real estate last year, you could have earned a savory 40% return by shorting  iShares Dow Jones US Real Estate . So logic would hold that owning UltraShort Real Estate ProShares would have produced a positive 80% return, right? Absolutely wrong. I say absolutely because, in absolute terms, you would have lost even more money using the double-short fund—which is supposed to go up when the index goes down. The disappointing truth: the funds worked like they were supposed to. Before you declare my last statement as blasphemous, the fund did indeed perform as the prospectus declared it would. It is the investor that held the leveraged or inverse fund for more than a single day that erred in practice.

Buying the double-short fund would have produced the most negative of investing emotions: right thesis, wrong execution.

Maybe international and real estate examples don't suit your fancy. Let's move over to the energy sector with sister funds Ultra Oil & Gas ProShares and UltraShort Oil & Gas ProShares .

Oil and gas producing stocks went for a wild ride in 2008, spiking for the first seven months of the year and cratering the rest. So which of these leveraged ETFs made money for you? Neither. They both lost, with DIG down 69% and DUG down 19%. And again, the funds worked like they were supposed to.

Why Joe Camel on the Label Trumps Warnings of Death
We laud ETFs for their transparency, tax efficiency, low costs, and liquidity. It's no wonder this group has continued to attract new assets even as the market has floundered. But just because these funds are transparent does not mean that a potential investor does not need to look under the hood before purchasing. There's more to the structure than the name implies.

It's pretty easy to understand why some investors would be attracted to funds that promise double returns. For example, let's look at the uninitiated investor that is considering a purchase of the NASDAQ 100, to which investors can easily gain exposure by buying  PowerShares . Here's the typical (misguided) thought process:

1) I'm convinced that QQQQ will go up 10% a year, so I'd like to own it;
2) But there is a fund,  Ultra QQQ ProShares that promises 2X the Nasdaq's return;
3) And 20% is more than 10%;
4) So I'll just buy the leveraged fund (QLD) and be twice as happy.

Seems like a reasonable conclusion, right? After all, the fund's literature clearly promises twice the daily return of the index. But the key word is daily. Daily is not monthly, and it's definitely not annually.

In every leveraged ETF report that we write, we warn investors that the math behind daily compounding will not work because of compounding arithmetic and constant leverage, but I get the feeling that the message is not getting across. I'm visualizing many readers' eyes becoming glazed at the very thought of walking through the algebra, so I'll try to make it as exciting as algebra can get. But please stick with me.

I think that we can we all agree that Albert Einstein was pretty smart. Legend has it that the theoretical physics' MVP of all time famously stated that "the most powerful force in the universe is compound interest." Many people have been persuaded to start investing after seeing this very simple example of compounding's magic. Let's say you put $100 in a savings account that pays 10% per year. After one year, you'd have made $10 in interest ($100 multiplied by 0.10), so your balance stands at $110 (your original investment of $100 plus $10 interest). If you leave the entire sum in the account, at the end of year two you would have $121. With the same 10% interest rate, you made $11 ($110 multiplied by 0.10) in year two versus $10 made in year one. As the adage goes: "Your money is working for you." Continue this same math for seven years, and your account would nearly double, ending at $195. If you divide the $95 you made over seven years, your average return would be 13.55%. Clearly, the average return on your initial investment exceeded the interest rate of 10% that occurred every year, or the rate that compounded.

But there is one interesting characteristic in this example that does not apply to the stock market: The returns were positive in every single period. Stocks tend to wax and wane from day to day, going from positive returns one day to negative the next. It's true that stocks, on average, have produced higher returns than fixed-income over long periods of time, but we've already demonstrated that average returns and compounded returns are very different animals. The point I am trying to make is that coming up with an actionable investment thesis (i.e. stocks look cheap) is difficult enough. Trying to also predict the exact timeframe over which your idea will become reality is even more difficult. Finally, actually detailing the path--knowing how volatile the daily price swings will be and in which direction--is nearly impossible. If you intend to hold leveraged or inverse funds beyond their compounding periods, you'd have to be right on all these factors to get double the index's return. In other words, when employing leverage and compounding returns, predicting your return is only part of the challenge. You also have to correctly predict the path the investment is going to take.

Notice that Einstein declared that compound interest is very powerful, but powerful forces can work both for and against you. Interestingly enough, anytime you compound a negative return, its impact is always more pronounced than a positive compounding of the same magnitude. I'll demonstrate with a two-day example.

Let's say you make a $100 investment in each of three funds. One is a simple investment in an index. Then you have two leveraged funds that compound daily; one is double-long and the other is double-short (returning twice the inverse of the index). After one day, the index returns 10%. The index value would then be $110. The double-long would add 20% and end at $120, and the double-inverse would lose 20% and end at $80.

On day two, let's say the index loses 10%. That means that the average return [(10% -10%)/2] would be zero. However, the index itself would end at $99 because 10% of $110 is $11, and $110 minus $11 is $99. The fund that promises double the return of the index but compounds daily would end at $96. Remember, this fund started the day at $120. Its return for day two is -20% (double the index's loss), and leaves it with a $24 loss for the day. So, $120 minus $24 is $96. The double-short fund would also end at $96 because 20% of $80 is $16, and $80 plus $16 is $96.

If you were to repeat 10 consecutive days of up 10% days followed by down 10% days, both of the leveraged funds would end up at $81.54, which is a sizable difference from the $95.10 the index would end at. Repeat this process for only six months, and your 'investment' in either of these leveraged funds would stand at only $2.54. Yes, that's a 97.46% loss. Talk about tracking error.

That's why compounding of daily returns is the dead horse that apparently needs a little more beating. Leveraged and inverse ETFs are NOT meant to be held as long-term investments. Let me repeat myself: Very bad things not only can happen whenever you hold these ETFs longer than their indicated compounding period (typically one day for stock-based ETFs, sometimes monthly for commodities), you are almost mathematically guaranteed to get a return that is not double that of the index. In fact, the longer you hold one of these funds, the probability that you will get nothing close to double the returns increases. Not only will the magnitude of your returns bounce around, you might not even get returns that are in the same direction as the changes in the index. (I'm not making this up. Please look at the above graphs again).

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Featured Video: Returns at These ETFs Could Shock You
Due to how leveraged and inverse ETFs are compounded, volatility can lead to wildly unexpected results at these funds, explains Morningstar ETF analyst Bradley Kay. Click to watch.