Exchange Traded Funds (ETFs) have become popular investment options and, as a result, a staple of individuals’ investment portfolios since their introduction in 1993 with the S&P 500 Depository Receipt (SPDR, now traded as “SPY”). Investments in ETFs are touted for their ease of trade, efficient means of diversifying investments, lower expense ratios and possible tax efficiencies. These benefits have helped drive investments in ETFs by the end of 2016 to approximately $2.5 trillion, with net flows of more than $200 billion, according to FactSet.
Given this rise in popularity and the ease with which investors can invest passively, different types of ETFs have been created, including equity, bond, international and leveraged ETFs. SPY tracks long-term returns of the S&P 500 index and provides investors exposure to the S&P 500 index. For example, if an investor purchased one share of SPY today and over the next year the S&P 500 index’s return was 10 percent, the investor would expect an approximate return of 10 percent.
In 2006, leveraged ETFs were created to allow investors to increase their exposure to an underlying index. For example, “SSO” (ProShares Ultra S&P 500 ETF) seeks to provide investors with returns equaling two times the daily performance of the S&P 500 index. An investor may think this is a superior investment relative to SPY, as now the investor could expect twice the returns of a SPY investment. Unfortunately, that is not correct. The goal of all leveraged ETFs is to provide leveraged daily returns on an index, not the long-term holding period return of investing in the index.
Consider as an example a two-day investment in the SSO. You purchase a share of SSO when the S&P 500 Index value is 100.00 and make 5 percent on the first day, closing at a value of 105.00, resulting in a gain of 10.00 percent for SSO and a closing index value of 110.00 for SSO. The next day the S&P 500 Index loses the previous day’s gain, closing at a value of 100.00. An investment in SPY would be back to even, but an investment in SSO would result in a closing value of 99.52, resulting in a 0.48 percent loss on the investment. This is a result of the compounding risk associated with leveraged daily returns.
The increased popularity of ETFs has resulted in the creation of new ETFs to satisfy investor needs. However, investors must understand underlying investment risks by reading the investment prospectus. Leveraged ETFs provide short-term investors the opportunity to leverage an investment without directly using options or margin. However, leveraged ETFs were created to generate performance consistent with daily returns; daily rebalancing and compounding daily returns can result in long-term deviation from the return of the index. Collectively, leveraged ETFs are inherently riskier investments than non-leveraged ETFs and may result in unexpected negative returns. Long-term investors should be wary of leveraged ETFs in their investment portfolio.
Disclaimer: Nothing mentioned in the article should be construed as a recommendation for any security. Nor is it intended as financial, investment, legal, or tax advice. Individuals should seek professional advice concerning their unique situation.
Seth Hoelscher joined the faculty at Missouri State University in the fall of 2016 as an Assistant Professor of Finance. His research focuses on energy finance, disclosure, and corporate risk management.
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