Leveraged ETFs and Volatility: A Powerful Mix - ETF News And Commentary
November 08 2012 - 5:39AM
Zacks
The last five years have certainly been a rocky one for
investors in pretty much every corner of the market. In the time
period, the S&P 500 was more or less flat although it
experienced two incredible stretches in which it first lost roughly
half of its value in one, and then proceeded to double over the
next few years to recoup nearly all of its losses.
These shifting trends—which put the S&P 500 back within
striking distance of its all-time (non-inflation adjusted)
high—have also obviously led to a very high level of volatility for
the benchmark index. In fact, according to data from XTF.com, the
standard deviation for SPY over the past five years was 26.4%, a
level that is roughly 75% higher than what investors have seen in
the same index over the past few months, underscoring just how
uncertain markets have been over the past half decade.
Unsurprisingly, the volatility levels go up even more when
investors take a closer look at some of the leveraged and inverse
funds on the market. For example, two of the oldest leveraged and
inverse ETFs tracking the broad market out
there—SSO and SDS—both have five
year standard deviation levels over 50% (see the Guide to the 10
Most Popular Leveraged ETFs).
This shouldn’t be too surprising to investors, as SSO and SDS
track the return of the S&P 500 using, respectively, 2x and -2x
leverage, albeit on a daily basis. Given this, one should probably
expect these two funds to have roughly double the standard
deviation that their underlying index exhibited over the same time
period.
Yet beyond these two, investors have also seen incredible
standard deviation levels in a number of other leveraged and
inverse ETFs in the time period in question. While leveraged and
inverse financial ETFs, basic materials, and oil ETFs all saw
extremely volatile five year periods, they all paled in comparison
to one segment of the economy in this respect, real estate (see Is
ROOF a Better Real Estate ETF?).
The -2x and 2x real estate ETFs, the ProShares Ultra
Short Real Estate Fund (SRS) and the ProShares
Ultra Real Estate Fund (URE), both experienced truly
tremendous five year periods from a volatility perspective, with
readings above 90% for both funds. While the leverage was certainly
a necessary component to bring about such extreme standard
deviation levels for these relatively old funds, the general trend
of the real estate market was also a key contributor to the
volatility as well.
What Happened?
After both URE and SRS’ debut in early 2007, the broad real
estate market reached a historic high, spurred by a variety of
factors. Soon after that, as we all now know, real estate cratered
in a catastrophic fashion leaving the sector decimated (read Three
Best Performing Small Cap Growth ETFs).
This was especially true for URE and SRS as these two ETFs are
dominated by REITs in the American market. Furthermore, mid caps
and small caps take up a big chunk of assets—nearly 50% at this
point—so higher volatility levels should be expected anyway.
This slump was followed by a long and steady rise back to nearly
breakeven—granted with a few modest drops along the way. The
performance was actually enough to move the iShares Dow
Jones US Real Estate ETF (IYR)—a product that tracks the
same index as URE and SRS—to a performance of -8.7% for the
trailing five year period (see Leveraged and Inverse ETFs: Suitable
Only For Short Term Trading).
However, when leveraged ETFs are seeing high levels of
volatility, along with deep trends, the impact on long term
performance is usually devastating. That has certainly been the
case for the leveraged real estate ETFs as both are down more than
60% for the time frame in question, with SRS losing more than 98%
of its value in the past half decade.
The Bottom Line
While leveraged ETFs can certainly work in your favor during
short-term periods, long term performance is usually terrible for
these products. This can be especially the case during periods in
which deep trends form and a great deal of gains evaporate (see
Understanding Leveraged ETFs).
URE has actually been a pretty solid performer over the trailing
three year period—up 142%-- but it hasn’t been able to shake the
turmoil of the 2008-2009 crisis. Meanwhile, SRS was up roughly 119%
at one point in the trailing five year period, but the long term
recovery of the housing sector helped to erase these gains over the
long haul, making the ETF actually the underperformer of the
two.
So while leveraged and inverse ETFs can certainly help portfolio
returns when you pick the correct side, there are also significant
long-term risks to these potent instruments as well. As we have
seen in the real estate ETF example above, the combination of
performance trends and long term volatility can be extremely
devastating for investors, once more demonstrating that leveraged
funds need to be monitored closely and only utilized for short time
periods.
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ISHARS-DJ REAL (IYR): ETF Research Reports
PRO-ULSH S&P500 (SDS): ETF Research Reports
PRO-ULS RE (SRS): ETF Research Reports
PRO-ULTR S&P500 (SSO): ETF Research Reports
PRO-ULT RE (URE): ETF Research Reports
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