4X ETFs: An Investment Innovation No One Needed

By Jordan Wathen Markets Fool.com

As a fan of horse races and free markets, I'm all for letting law-abiding adults lose money as they please. But there's something about mixing elements of a casino with retirement accounts that makes my stomach churn.

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Yesterday, the Securities and Exchange Commission approved two new ForceShares exchange-traded products that will allow ordinary investors to gain or lose four times the daily return of the S&P 500 by speculating from the comfort of their own home. If the index rises or falls just 5%, investors who hold the shares would stand to gain or lose 20% of their investment in just one trading day.

At first it sounds interesting, maybe even fun. But then I'm left to think about the consequences. I worry that the SEC just made it easier for average Americans to treat their individual retirement accounts with all the care of a poker night bankroll.

A product that almost went extinct

As recently as December 2015, the SEC was pondering a rule change that would kill off the riskiest of leveraged funds. It planned to cap the use of derivatives, a key ingredient for creating leverage, so that ETFs would be effectively capped at 2X. Some SEC regulators, consumer advocates, and others feared that any more than 2X leverage is too much for ordinary investors.

They're probably right. The truth is thatthe primary problem with leveraged ETFs isn't with the funds themselves. They work just fine. The problem is that no one reads the warning labels hidden in thick prospectuses. In short, the danger is in how people think they work, rather than how they actually work.

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A quirk in the math

In 2015, a3X leveraged fund,ProShares Ultra Gold Miners, went public in a quiet debut. Less than two years later, the fund has crumbled, losing more than 38% of its value. Meanwhile, a fund that is designed to track the same index, but without leverage, is up 2% over the same period.

How does three times a 2% return equal a 38% loss?

Leveraged funds fail to produce leveraged returns of their index over the long haul because they are designed to generate the advertised return over a span of just one day.

I created a scenario in which a leveraged fund generates 3X the daily return of an unleveraged fund over the course of a three-day period in the table below. While the leveraged fund does its job spectacularly over a single day's time, its returns start to deviate from the 3X return investors expect over longer periods, as daily compounding throws its returns off the path that many investors anticipate.

Fund type

Day 1

Day 2

Day 3

Total return

Unleveraged

2%

(4%)

(1%)

(3.06%)

3X leveraged

6%

(12%)

(3%)

(9.52%)

Source: Author. Numbers are for illustration only.

Notice that the daily returns of the 3X fund are exactly equal to three times the return of the traditional unleveraged fund. However, when the returns are calculated over the full three-day period, the 3X fund actually ended up amplifying the return of the unleveraged fund by 3.11 times, returning negative 9.52% compared to the 3.06% loss of the unleveraged fund.

This isn't an anomaly or mathematical error. If I were to extend the timeline further, the amplification would deviate even further from the 3X return many investors expect. It's a mathematical certainty.

Of course, this isn't a failure of the product. The leveraged fund is providing exactly what it promises, which is a return equal to three times the daily return of this specific index. The problem is that the public doesn't bother to think about the daily part of the equation. Leveraged funds are only meant to be held for a short period of time, preferably a trading day or less.

But many investors dive in head first, thinking that if the market is expected to go up in value over time, then 3X must be so much better than 2X, or even 1X. And the leveraged fund industry is plenty happy to cater to their greed: Although these products are perhaps too speculative for individual investors, individuals are by far the industry's biggest customer.

A 2012 analysis by Deutsche Bank found that retail investors hold proportionally more leveraged funds than plain-vanilla ETFs. In fact,85% of assets in 2X funds and 91% of assets in 3X funds were owned by retail investors. By contrast, retail investors own less than half of all assets in ordinary unleveraged ETFs.

4X ETFs have more to do with gambling than sound investing. Image source: Getty Images.

Crafting a loophole

A rule by the name of Regulation T generally sets the standard for just how much leverage a retail investor can use to buy stock. Since 1974, the initial margin requirement has been set to 50%. Thus, to buy $1,000 of stock, an investor would have to pony up $500 of their own cash to secure a loan for the remaining $500 from their broker.

This rule generally protects individual investors from blowing up their accounts, while protecting brokers from undue losses in the event stocks crater.

The genius of the leveraged fund is that it circumvents Regulation T rules on leverage. By purchasing a 4X leveraged fund, investors can take twice the risk that they would be allowed to take if they used margin to purchase a plain-vanilla ETF. Remember, Regulation T applies to leverage on brokerage accounts, not funds. It's really pretty brilliant. Put the leverage in the fund, not in the brokerage account, and charge a fat fee for your hard work.

Is 4X too much? Why not 5X or 8X?I'll admit there is no clear and obvious line to draw. Eliminating margin in the late 1940s was probably going too far. Allowing investors to leverage up at 10X in the years leading up to the Great Depression ended in obvious disaster we would be silly to repeat.

For what it's worth, only once has the S&P 500 come close to a one-day decline that would send a 4X leveraged fund to zero. That was in 1987, when the S&P 500 plunged 20.47% on a day forever known as Black Monday. If a 4X ETF were around then, it would have lost nearly 88% of its value in a single trading day.

Somewhat amusingly, ForceShares has minimally planned for a one-day disaster in which the S&P 500 declines by 25%. In a regulatory filing, it points out that it will purchase insurance in the form of put options, protecting itself and its investors from a complete loss.

But don't get your hopes up. Per its illustrative example, if the S&P 500 declines by 25% in a single day, investors would lose just 94% of their capital, rather than the 100% loss you might assume.

I suppose something is better than nothing.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.