Facts and Fallacies About Leveraged Funds
Leveraged and inverse funds, which seek to provide a multiple (e.g., 2x or -2x) of the returns of an index or benchmark each day, are useful tools for knowledgeable investors to implement a variety of investment strategies. However, as often happens with innovations, misperceptions about leveraged and inverse funds have caused some confusion.
Below are some common misconceptions and a discussion of the facts.
- Fallacy: Leveraged and inverse funds don't do what they are supposed to do.
Fact: Most leveraged and inverse funds are designed to provide a multiple (e.g., 2x or -2x) of the return of an index or other benchmark, for a single day, before fees and expenses. Historically, leveraged and inverse ETFs have generally done a good job of achieving their daily investment objectives.1 However, if the funds are held for longer periods, performance may be higher or lower than the index return times the fund multiple, due to compounding.
- Fallacy: If you hold a leveraged or inverse fund for more than one day, you will always underperform the fund multiple times the index return.
Fact: As mentioned above, leveraged and inverse fund returns over periods beyond a day can be higher or lower than the index return times the fund multiple. For example, a fund designed to provide -2x the return of an index each day might return more or less than -2x index returns over longer periods. This is in part due to compounding of daily returns.
- Fallacy: Because of compounding, leveraged funds can't ever produce returns close to the fund multiple times the index return over periods—even short periods—of more than one day.
Fact: It is not possible to predict future performance of any investment. However, Joanne Hill, PhD, and George Foster, CFA, both of ProShare Advisors, published an historical study that showed a high incidence of returns approximating the daily target over short periods.2
Four factors significantly affected how close returns were to the index return times the fund multiple: the length of the holding period, index volatility, whether the multiple is positive or inverse, and its leverage level. Longer holding periods, higher index volatility, inverse multiples and greater leverage, each led to returns farther from the multiple times the index return.
Investors whose goal is to get close to the fund multiple times the index return over time should closely monitor their holdings and consider a rebalancing strategy.
- Fallacy: Leveraged and inverse funds are only used in aggressive ways that increase risks in portfolios.
Fact: While leveraged and inverse funds have their own risks, they can be used in an effort to help manage risks in a portfolio. Examples include using an inverse fund to help hedge against potential downturns or using a leveraged fund to get a target exposure in a market segment, while keeping some cash out of the market.
- Fallacy: Leveraged and inverse ETFs are a new investment concept—the first to provide investors with leveraged and/or short exposure.
Fact: Leveraged and inverse ETFs are relatively new, but many investments provide leveraged and inverse exposure. Mutual funds virtually identical to leveraged ETFs were introduced in 1993. Also, many open- and closed-end funds have used leverage and shorting strategies for decades. Some funds invest in highly leveraged companies or in hedge funds that use leverage and short exposure extensively. Many public companies use leverage, some more than 20 to 1 (based on assets to equity).
- Fallacy: Leveraged funds are more volatile than other investments available through a typical brokerage account.
Fact: Many other investments, including individual stocks and non-leveraged funds, can be as volatile as, or more volatile than, leveraged funds. In an historical study of stock volatility conducted by ProShare Advisors, for the 10 years from 2000–2009, it was found that on average over this period, 42% of the individual stocks in the S&P 500 were more volatile than a strategy based on 2x the daily return of the S&P 500.3 Leveraged funds can be volatile and have specialized risks. Read the prospectus before you invest.
- Fallacy: Leveraged and inverse ETFs are more complicated products than other ETFs.
Fact: There are now more than 900 exchange-traded products in the U.S., offering access to a broad array of markets and strategies, including narrow market slices, foreign markets, commodities, currencies—and leveraged and inverse strategies. Some ETFs track unfamiliar markets; others pursue sophisticated investment strategies; some use complicated investment instruments. Like specialized tools, these ETFs are designed for specific jobs—and they may not be right for investors who lack the specialized knowledge to use them. Investors considering any ETF should be sure they understand the investment and read the prospectus before investing.
- Fallacy: It's possible to create leveraged and inverse funds that provide the same multiple of index return to each investor regardless of when they buy their shares or how long they hold them.
Fact: Most leveraged and inverse funds reset exposure daily to provide consistent exposure each day the markets are open. If these funds did not reset their exposure daily, the leverage of the funds would vary each trading day. For example, if a fund did not reset daily, an investor buying a 2x fund on the first day after a reset might get 2x exposure, but the investor buying several days or weeks later could get greater or less. Also, no matter how often a fund resets its exposure—daily, weekly, monthly—the return on shares held longer than that period would be affected by compounding and could be more or less than the multiple times the index return.
Read our educational brochures for more information:
Geared Investing: An introduction to leveraged and inverse funds
Geared Fund Performance: Understanding leveraged and inverse funds
Jun 16, 2010
1Source:ProShare Advisors LLC daily monitoring reports since inception. Past performance is not a guarantee of future results.
2Study by Hill and Foster of ProShare Advisors, published in the September/October 2009 issue of Journal of Indexes.
3Source: ProShare Advisors analysis. Volatility is defined as the standard deviation of daily returns. The analysis of S&P 500 volatility does not reflect fees or expenses. Results for other indexes would be different. Data source: Bloomberg.