Performance Flaws in Leveraged And Inverse ETFs

Trend: Leveraged and inverse ETFs do not perform as expected due to tax distributions and tracking error. 

Jim Cramer on CNBC has been ranting about the problems effects of the double short financial ETF SKF.

Simon Maierhofer at ETF Guide describes the illogical returns of leveraged and inverse ETFs.

Link: ETF Guide: Leveraged And Short ETFs - 3 Flaws You Should Know.

...short ETFs are a great and powerfull tool but they have their quirks and limitations. Short and leveraged ETFs are "power tools" and will punish the ETF investor if used irresponsibly.

How to lose 70% in 30 days or less

To illustrate, the UltraShort Real Estate ProShares (SRS) dropped from $259 a share to $57 a share in less than a month. $10,000 invested in SRS would have been reduced to a mere $2,200. In less than 30 days, SRS dropped twice as hard as the S&P 500 (SPY) and Dow Jones (DIA) in the entire year.

If used responsibly, there is no reason to shy away from short ETFs. You can thrive with short ETFs as long as you are aware of certain quirks.

Short ETFs and taxes

The two most established short ETF providers, Rydex and ProShares paid out capital gains tax distributions earlier in December (read related article here). The distributions were huge, affected nearly all short ETFs (also called inverse ETF or bear ETFs) and ranged from 4% to 86%.

In essence, SIJ and any other short ETFs affected by tax distributions, maintained their value. However, part of the ETFs share price is paid directly to investors to account for a different tax treatment. If you own short ETFs within a tax-deferred account, this is a moot point.

Not all short ETFs distributed short term gains. Some distributed long term gains or a combination of long term and short term gains. Long term gains are taxed at a more favorable 15%.

Short ETFs and tracking error

Short ETFs are designed to provide 100%, 200% or 300% the inverse (opposite) DAILY performance of the underlying index. It is a common misconception that inverse ETFs are made to attain 100%, 200% or 300% the inverse performance over longer periods, such as weeks, months or years.

Several factors contribute to this effect. According to ProShares, the most significant one is index volatility and its effect on fund compounding. In general, periods of high index volatility will cause the effect of compounding to be more pronounced, while the lower index volatility will produce a more muted effect.

A look at the ETFs and short ETFs tracking the financial sector illustrates the “tracking-error”. Over the past six months, the Financial Select Sector SPDR (XLF) lost 42%. The UltraShort Financial ProShares (SKF) lost 18% while the Short Financial ProShares ( SEF) gained 15%. In a perfect world, SKF (200% inverse) would be up 84% followed by a 42% gain in SEF (100% inverse).

Even on a daily basis, short ETFs don’t always deliver on their promise. A few days ago, the Nasdaq (Nasdaq: QQQQ) was up 2.67% while the 200% inverse Nasdaq UltraShort ProShares (NYSEArca: QID) only lost 4.33%. Similarly, the S&P 500 (AMEX: SPY) shot up by 2.44% while the UltraShort S&P 500 ProShares (NYSEArca: SDS) fell by only 4.49%.

Short ETFs are a valuable tool to hedge your portfolio or speculate on market movements. Nonetheless, if you want a mirror image of the underlying index, consider shorting an ETF that tracks the index rather than buying a short ETF.