Leveraged ETFs are Complex?

It’s not exactly grabbing headlines, but our nation’s regulatory watchdogs are on the scent of yet another scourge from which investors need to be protected: leveraged ETFs. Apparently, these things are like snakes in the grass, just waiting to spring at poor innocents who wander by.

Several brokerages have taken steps to discourage their clients from buyingNYSE-Mod-Small leveraged ETFs and in some cases prohibit it altogether. The folks at Motley Fool have been waving people off them. The association of state securities regulators named leveraged ETFs as one of their Top 10 Investor Traps, along with Ponzi schemes and currency and gold bullion scams.

And just last week, FINRA, the financial industry’s self-regulation body, announced changes to the margin requirements for buying leveraged ETFs that go a long way towards destroying their usefulness. A FINRA spokesman called leveraged ETFs ”very complicated, with a high element of risk."

Really?

I guess it all depends on what you are used to. Leveraged ETFs are more volatile than their unleveraged counterparts, but that’s hardly a hidden gotcha. It’s kinda the whole point. Most are based on indexes that are less volatile than individual stocks. FINRA doesn’t seem to have a problem with individuals buying volatile biotech stocks and even stock options.

And leveraged ETFs are more complicated than unleveraged ETFs. But let’s get real folks, they are way less complicated than all sorts of things we think consumers can handle. Auto leases and cell phone contracts pop into my head as examples.

A leveraged ETF is designed to magnify the returns of an underlying instrument, usually an index. So, for example, the Rydex 2x S&P 500 (ticker RSU) is engineered to produce twice the S&P return on any given day. It does this by borrowing money, but the mechanics aren’t that vital. The important point is that it and it’s brethren do a pretty solid job of what they say they do, which is, I repeat for emphasis, deliver a stated multiple of an index return over a single day.

The problem is that, apparently, practically all individual investors, pundits, brokers, and regulators think that an ETF that matches twice the S&P each day ought to therefore match twice the index over longer periods too. But the math, and in this case I am referring to junior high school algebra, doesn’t work that way.

Let A and B be the returns for two consecutive days. Then the return for the two day period is:

r = ((1 + A)(1 + B)) –1 = A + B + AB

Got it? That wasn’t so hard. Now suppose we have a fund that gives us twice the return. What is its two day return?

r = ((1 + 2A)(1 + 2B)) – 1 = 2A + 2B + 4AB

That’s not twice what the unlevered version got you over two days. You will note that if A and B are relatively small, for example 1%, then the AB term is tiny and ignorable. If they are large, e.g. 10%, then AB starts to matter. Also note that if one of A or B is negative, then the AB term will be negative. This is why if you gain and then lose (or lose and then gain) 10% you wind up with 99% of what you started with.

All this is pretty obvious stuff to some of us. But I’ve searched the web and can’t find anywhere that explains what is nothing more than a common misunderstanding about math. A few places give a hypothetical example and others a real-life one, but nowhere is the general principle explained. And many of the media reports give no explanation at all, leaving the reader with the vague impression that something sinister is afoot with these evil sounding leveraged ETFs.

I’m not sure that the world needs leveraged ETFs, so I’m not particularly upset at the effort to run them out of town. But the core problem here is not that Wall Street is preying on naive investors, it’s that nobody seems willing or able to help those investors become less naive.

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