Leveraged and Inverse ETFs have become all the rage, thanks to the flexibility and versatility they offer investors. But there is a dangerous hidden factor here, and if you trade them you should be aware...

I have to begin today’s piece with an apology. I made a mistake in recent weeks – having to do with a trade recommendation in these pages – and it's a real forehead-smacker.

Now, normally I'm not big on apologies when it comes to the trading game. As legendary mechanical trader Larry Hite pointed out, there are actually four types of bets – good bets, bad bets, winning bets and losing bets. The idea is, you always want to make good bets (i.e. good trades) and then let the results come as they may. “Getting your money in good,” as poker players like to say, is something you can always control regardless of what future cards come. The fact that sometimes a good bet doesn't work out, and sometimes a bad bet does work out, shouldn't sway your focus from always making the smart move.

So when a good bet doesn't work out, that's just part of trading. Nobody wins without losing on occasion, except Bernie Madoff. (And he took the biggest loss of all in the end.)

So why the mea culpa? Because every once in a while, what at first appears to be a good bet actually turns out to be a bad bet... which, by our "four types of bet" terminology, means something different than whether the trade won or lost.

And when a "bad bet" sneaks into the lineup for an unacceptable reason – like a blatant research oversight – I feel it's the right thing to do to own up.

Fortunately, in explaining the nature of how I messed up – and in light of what I've discovered – I'll hopefully have the chance to do three things here. My goal is to make amends for the error, help you save money on future trades, and offer up a new and powerful insight all at the same time. Let's see if I can pull it off....

Never to Return

Here is the mistake. A few weeks ago, in “A Simple and Powerful Way to Bet Against the Government (Part Two),” I recommended the Financial Bear 3X shares (FAZ:NYSE) as a sort of perpetual call option against financial Armageddon.

This is the paragraph where I really botched it:

A month or so ago, FAZ was above $100 per share – roughly 10 times where it trades now. In the dark days of November 2008, it was above $200 per share – twenty times where it’s trading now. If the financials go to hell in a handbasket... that is to say, if the euphoria evaporates and the big banks wind up back on life support... who’s to say FAZ couldn’t head back to triple-digit levels.

FAZ is never going back to $100 per share. It could conceivably see $15 or $20 again from here – I wouldn’t rule that out. But triple digits? Not gonna happen. I doubt it will ever see $50 again, or even $40, making my original reason for getting excited about FAZ a bum steer.

I imagined FAZ as a sort of “perpetual call option” without time decay, but what I’ve discovered is that these leveraged ETFs are a lot more like options (in the “decay” sense) than I realized.

The reason why this is true – and the thing I overlooked – has to do with the way double- and triple-leverage ETFs are constructed. The gory scientific details are laid out in a paper by Minder Cheng and Ananth Madhavan of Barclays Global Investors, titled “The Dynamics of Leveraged and Inverse Exchange-Traded Funds.” It makes for pretty dry reading with plenty of complex mathematical formulas – if so inclined, you can find an online PDF copy here.

Microstructure Effects

The reason FAZ can never go back to $100 or $200 (as I now know, but did not realize before) is because of something Cheng and Madhavan refer to as “microstructure effects.”

These “microstructure effects” function a bit like radioactive decay. The longer a leveraged ETF exists, the more radioactive decay it sees... with the old highs fading away, never to be regained.

Why does this happen? Specifically, it has to do with the daily tracking nature of the ETF. The easiest way to explain is with a short example.

First, imagine you have a leveraged ETF designed to track twice the performance of Index XYZ on a daily basis. So when index XYZ goes up 2% in a day, the ETF goes up 4%, and so on.

Now let’s say this index has a series of extremely wild days – down 5%, then up 5%, then back down 5% again. Down five, up five, down five. What happens to the ETF, assuming it began at $100?

• On day one, the index declines 5% – so the ETF goes down 10%, to $90.
• On day two, the index rises 5%, so the ETF goes up 10% (double the return), from $90 to $99.
• On day three, the index declines 5% again – so the ETF falls 10%, starting from $99 now, to wind up at $89.10.

After three days of nickel ups and downs, Index XYZ is down about 5.24% from where it started. But the double leverage ETF that tracks it is down 10.9%.

If the tracking performance were to stay at exactly double, the ETF would have to only be down 10.48% or thereabouts. But it’s actually down more than that.

That extra little bit of loss, a touch over 0.4% in this case, is the microstructure effect at work. When you track something with leverage on a day-to-day basis, those microstructure effects build up over time... and the more volatility that exists, the faster they add up.

So what we have with leveraged and inverse ETFs, then – at least the ones that track on a daily basis – is a recipe for inevitable performance lag over time. These things are like radioactive instruments, with volatility the radioactive component. The more volatile an inverse or leveraged ETF is, the faster the half-life breaks down.

Don’t Bring Me Down

Microstructure effects have an impact on all leveraged ETFs, regardless of whether they are “bullish” or “bearish” in orientation, and the decay aspect always points in one direction – down.

We can see this with an example that Cheng and Madhavan used in their paper, referring to DIG and DUG. DIG is the Proshares Ultra Oil and Gas ETF (DIG:NYSE). DUG is the inverse, the Proshares UltraShort Oil and Gas ETF (DUG:NYSE).

Given that DIG and DUG are designed to mirror each other – one leveraged bullish to oil and gas and the other bearish – you would expect their performance to be mirrored too. But that’s not what’s happened in reality. Over the past nine months, DIG and DUG both went down... a lot.

As the chart shows, DIG and DUG – which are supposed to run inverse to each other – instead both saw significant declines over an extended period, one down 40% and the other down 70%. The daily tracking nature of these leveraged ETFs simply results in a slow and steady erosion, regardless of whether the instrument being tracked is moving up or down.

Bad News and Good News

There is bad news and good news here. First the two bits of bad news, and then the good.

The first piece of bad news, obviously, is that I steered you wrong in FAZ if you bought thinking a return to triple-digits was a realistic possibility. It simply isn’t – not unless they execute a massive reverse stock-split on the shares, which isn’t the same thing. This constituted a research failure on my part – I just didn’t look deeply enough into the construction of these things – and for that I again apologize.

The second piece of bad news is that leveraged ETFs are kind of a rotten deal for investors. In particular, many investors have grown excited over the possibility of having access to leveraged instruments in their retirement accounts.

The juicy promise of something like SDS, the ProShares Ultra Short S&P 500 ETF (SDS:NYSE), is that you can go long SDS in your IRA account and enjoy the benefits of a leveraged bearish position with all the ease of just buying normal shares.

Knowing what I know now, I no longer trust these inverse and leveraged ETF instruments from the standpoint of going long for a trade. The trouble is, even if you’re going long a supposedly bearish instrument – like SDS or DUG or TBT for example – you’ll still be fighting the hidden decay brought about by microstructure effects and dragging the ETF down over time.

So that’s the bad news. But I said there was good news too, and here it is: The decay aspects of leveraged ETFs just might make them even better vehicles to short!

Not Long Bearish – Short Bullish!

Here is what I mean. Let’s say I decided to take a bearish trading stance on the S&P 500. (Something not far from the realm of possibility I might add, given recent market action.) The conventional thing to do, being aware of the existence of leveraged ETFs and not wanting to mess with futures contracts, would be to go long (i.e. buy shares in) SDS, the Ultra Short S&P 500 vehicle.

But I don’t want to be long these sneaky instruments anymore, because of the established downward bias born of microstructure effects and inevitable decay.

So what I do instead? I go negative on the BULLISH vehicle, taking out a short position (or buying put options) on SSO, the Pro Shares Ultra S&P 500 Bullish ETF.

You see how that works? Because there is a persistent downward decay bias to these leveraged ETFs, the wind is in our faces whenever we go long these things, regardless of what the underlying “bullish” or “bearish” orientation is. Many investors who buy and hold leveraged ETFs of all kinds do not know this. And who can blame them? I didn’t realize it until just recently.

But to go short an inverse or leveraged ETF – and I mean going short the old classic way, by actually borrowing the shares – is to turn the tables and put the decaying aspect of microstructure effects in your favor.

So in a nutshell, my contrite advice to you is:

• If you’re long FAZ, recognize that it might go back to $15 or $20 but the old highs will never return (and again, my apologies – I will be doubly on my guard with exotic instruments from here on out).
• If you’re one of the many investors who have come to appreciate the versatility and punch provided by leveraged ETFs, be aware of the pernicious downward bias created by microstructure effects over time, regardless of whether said ETF is “bullish” or “bearish” in orientation to what it tracks.
• Next time you have a hankering to get bearish on something, don’t buy the “bearish” leveraged ETF... look to short the “bullish” one instead (or buy puts on it), and thus buck the system by putting microstructure effects in your favor.

Other Related Topics: Exchange-Traded Fund , Justice Litle , Macro Trader , Market Analysis

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