Paul Justice: Hi, I’m Paul Justice, ETF Strategist with Morningstar. Today I’m joined by Bradley Kay, ETF Analyst. And we’re here today to talk to you and raise some awareness about certain ETF products, leverage ETF’s and I want to give you a big warning a lot of people don’t know how this work. They are using them as long term holdings. There is an obvious short fall as to the structure of these bonds. They don’t work over long period of time for most people.
So we want to dive into that and raise some awareness on this campaign. Bradley, which funds am I talking about.
Bradley Kay: We’re talking about a series of leveraged and inverse funds put out by Pro-shares, right “x” direction which are labeled Ultra Short, two times inverse and these were all funds we chose various derivatives, generally futures or index swaps to try and match two times the daily return on an underlying index.
Paul Justice: Daily return, okay so the daily return. When I’m talking about the annual return, daily return so tell me how does that work exactly?
Bradley Kay: Now, the major problem there is that when you have the multiple day returns, it compounds differently from the way that most people would expect. So if you have say, let just look at two days in a row. And you have 10% movements of the S & P 500. The S & P 500, you have $100.00 in it. It goes up 10% and it goes down 1:26 the next day. You’ve gone to 110 and then down to 99, so you have actually lost one percent after those two days in movement.
If you go into a two times fund, you’ve gone up to a 120 on the first day because you gained your 20% but then you lose 20% and you go down to 96 because you have lost 24 points.
Paul Justice: Sure, I would have thought you have gone down to say 98 just twice the lost of the S & P but that’s greater than that.
Bradley Kay: Exactly, instead you’ve lost 4%, instead of one percent the original has, and it’s the same if you actually look at the double leverage short. So you would have lost 20% of the first day. You’ve gone down to 80%, 80. Then you would go up 20% from there, which means that you instead go to 96 once again, you’d be down 4% at the end of the two days.
Paul Justice: So either double long or double short it didn’t matter. I was down further because we had an up moved followed by a down move. But they were equal side’s moves, right 10% and 10%. It should have offset.
Bradley Kay: Well, not necessarily it’s because of the way that the leverage works in these funds where you take on more leverage as you go up higher of you take a less leverage as you get on lower instead you always have exactly two times whatever your position.
Paul Justice: Now we know how they kind of work over two day period. If I extend that out over multiple periods I imagine that drag becomes worst and say 10 days you’d be down to close to $80.00 on both the double long and the double short. It also laded between up 10% and down 10%. So over a period of time where the market didn’t trend in anyone way I’m putting on a losing bet.
Bradley Kay: Exactly, validity causes huge problems with these bonds and this isn’t just an academic matter we’ve actually seen this in practice.
Paul Justice: Let’s take a look at the examples because they are shocking, right? So let’s start with the real estate sector. We know as a whole year for real estate last year. You could have bought an ETF particular IYR or you could have short at this ETF either way that you want to look at it and let’s say you just tracked it, it went down 40% last year. Who spent here for real estate, right? How did the leverage funds performed?
Bradley Kay: Well, there’s an ultra long which then 22L.
Paul Justice: Well, that obviously. I would think, right? That if the long lost 40%, the double long priority lost 80%.
Bradley Kay: I’ve lost slightly more on unfortunately even now.
Paul Justice: Okay.
Bradley Kay: But there was a double short.
Paul Justice: I would have made a ton of money by buying that, right.
Bradley Kay: Exactly, you should have gain about 80% this what most investors would think, and that’s what the future solution would have got you, but unfortunately, you would have actually lost more than 40% in this fund.
Paul Justice: That sounds completely absurd.
Bradley Kay: That’s the way the compounding arithmetic adds them. That’s the way the volatility can pull down the returns on these funds.
Paul Justice: But and the fund performed exactly like to prospect the city would.
Bradley Kay: Exactly, if you look at the daily returns it actually tracked the index. It did two times the outset about the index was doing day in and day out. You would have had periods where you are having incredible gains and incredible losses. You would have had one point the year were you’ve been up nearly a 180%, but you would have to hit on right on that day because just a few days later you would have lost most of these gains.
Paul Justice: So I would have to know exactly when the market is going to moved, what direction is going to take, and how big those moves are going to be in order to make this an invest able idea.
Bradley Kay: It got good news such as hatches, but at the moment yes, for longer term investing and for taking on a speculative position. They can be extremely dangerous.
Paul Justice: Sure.
Transcription by:
Scribe4you Transcription Services