Leveraged ETFs and High School Level Mathematical Truths

Posted by kid dynamite

on April 3rd, 2011

There’s a common misunderstanding about ultra (leveraged) ETFs out there, but it makes me sad to see authors at the Wall Street Journal exhibit this ignorance and unawareness. Dave Kansas writes:

“Conversely, the ProShares UltraShort S&P 500 ($SDS), which makes a double bet against the S&P 500, is down 40% in the past year, which compares to a 13% gain for the S&P 500. That means the “double” bet against the index is doing worse than promised, highlighting another risk for such funds: They often fail to track their stated performance goals.”

I’m tempted to leave it as an exercise to my readers to figure out why I’m bothering to write this piece about how completely unacceptable it is for a writer at the U.S. Financial Paper of Record to make a statement like that (which demonstrates gross misunderstanding), but let me just give you a hint – from the ProShares UltraShort S&P 500 fund web page (emphasis THEIRS – not mine – they put it in bold face and italics for you):

This ETF seeks a return of -200% of the return of an index (target) for a single day. Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.

For readers who still don’t get it, let me lay it out there for you: compounded daily returns do not equal compounded long term returns. Make yourself a spreadsheet – do the math – it’s not rocket science.

-KD

ps – If you take your investment research one step further, not even to the full prospectus for SDS, but simply to the abbreviated summary prospectus which simplifies all the legal mumbo jumbo, the very first paragraph tells you:

“ProShares UltraShort S&P500 (the “Fund”) seeks investment results for a single day only, not for longer periods. This means that the return of the Fund for a period longer than a single trading day will be the result of each day’s returns compounded over the period, which will very likely differ from twice (200%) the inverse of the return of the S&P 500® (the “Index”) for that period. In periods of higher market volatility, the volatility of the Index may be at least as important to the Fund’s return for the period as the return of the Index.”

They also emphasize this point in bold-faced font two more times over the next 4 paragraphs.

Kid Dynamite is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com. If you click on my Amazon.com links and buy anything, even something other than the product advertised, I earn a small commission, yet you don't pay any extra. Thank you for your support.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Disqus