## Leveraged Decay

**Introduction**

Welcome to the first of several articles exploring the ups and downs, ins and outs, of leveraged ETFs. These articles will attempt to visually explain the dynamics of leverage as well as go deep into exploring the benefits and pitfalls of extreme volatility that accompany 2x and 3x ETFs. As a software engineer by day, I lack the investment and trading experience of many who do it for a living or on a daily basis. However, the articles and comments that I read online make it clear there are only a rare few that really understand how leveraged ETFs work for periods longer than a day. All that is required is an understanding of some very simple math. To explore long term leveraging effects, custom software was written measure leverage in a variety of scenarios. Questions such as the following will be addressed on this blog:

- What is leveraged decay?
- How much do leveraged ETFs lose due to decay?
- Are leveraged ETFs going to 0?
- What are the compounding effects of leverage?
- If I hold on to my leveraged bull ETF, will it eventually ride out the volatility in a bull market?
- What are the differences between using margin and a leveraged vehicle?

Many investors put money into leveraged ETFs without understanding the risks involved. Aside from the risk of potentially losing money at 2 or 3 times an underlying index, there is also a risk of losing money due to volatility if these ETFs are held for longer than a day. This loss is often called “Leveraged Decay” or “Volatility Decay.”

**A Simple Explanation**

Consider both a 1x and 3x ETF that have a starting price of $100 per share.

If the 1x ETF were to drop 10% on a particular day, the 3x would drop 30%. That puts the 1x ETF at $90 and the 3x at $70. Then on the next day the 1x ETF increases $10 back to its original value of $100, which is an 11.11% gain (10/90 is 11.11%). The 3x ETF will gain 33.33% of its $70 which is an increase of roughly $23. This puts the 3x ETF at a value of $93, for a loss of $7! Repeat this process again and again and over time the 3x ETF will continue to lose value while the underlying index always returns to $100. Here is a chart that shows this process happening 15 times (30 days).

As you can see, the 1x ETF is still at $100 while the 3x ETF has decayed 65% to end up at $35. A 10% move on a daily basis is not typical market activity, but it does help illustrate how significant decay can be. To demonstrate something more realistic, we can use the average SPY daily percent change from 1993 to 2008 which is 0.8%.

At such low volatility of 0.8%, decay has much less effect than when daily volatility is 10%. The 3x ETF above lost only 0.59% over 30 trading days. Here is a chart showing a full year of 0.8% volatility.

For 250 trading days with 0.8% volatility, the 3x ETF would lose around 5%. This doesn’t seem like the doom and gloom many blogs and articles have predicted for leveraged ETFs. The reason is because 0.8% daily volatility is far from the current average in 2009. A 30-day SMA of daily volatility for various 1x indexes will give us an idea of the volatility we have seen in the past year:

Back in November the indexes were at extremely high volatility levels, averaging between 4% and 6% daily moves. There were several days that reached higher than 10% resulting in +/-30% for the 3x ETFs. Such large daily moves can cause significant decay over time. An important point is that the amount of decay that occurs is not linearly proportional to the daily percent changes. In other words, 2% daily percent changes of an index does not result in twice the decay of 1% daily moves. Instead, it is significantly more. The following chart demonstrates the amount of leveraged decay for a hypothetical 3x ETF over 30 days for various underlying index daily move percentages (the ‘down’ day is not shown in order to make a smooth plot).

1x ETF Daily Change % | 3x ETF Loss % due to Decay |

1% | 0.91% |

2% | 3.61% |

3% | 8.03% |

4% | 13.99% |

5% | 21.24% |

6% | 29.44% |

It is evident from the table that the loss from decay grows significantly as the daily percent change increases. You will not see 6 times the decay comparing 6% daily moves to 1% daily moves; you will see over 29 times the decay. The bottom line: expect more much more decay from higher daily percent moves. This is a large part of why FAS and FAZ have dropped so much since their inception.

**A Closer Look at Decay**

Some key points to understand are:

- Leveraged ETFs move at a multiple of their underlying index on a daily timeframe.
- It is volatility on a daily timeframe (not intraday volatility) that causes decay.
- There is no absolute measure for loss due to volatility; a trend significantly affects the loss or gain.
- Decay is the result of simple percentage math and is not specific to leveraged ETFs.
- Between any two equal points, there is more positive percent gain than negative percent loss.
- As a drop % increases, its difference between the gain % needed to reach the original price increases.

Point number 5 says that no matter how many days it takes for an ETF to go down by a percentage, the total percentage to get back up to the original value will always be greater than the percentage down. As proof, from any two equal data points in a graph we can compute the sum of all percent gains and losses, and the gains will always be greater than the losses. Here is a chart of the SPY from the start of 2000 until May 2009 that includes such a calculation.

The light blue line (which is not important and just used as reference) is the % change since the start of 2000. The green data points represent the aforementioned calculation and show that between two equal price points in the SPY, the sum of the percent gains are more than the sum of the percent losses.

Point #6 can be confusing, and basically means that as the magnitude of a percent drop increases, in order to reach the original price, the difference between the drop percent and the gain percent increases. Better explained by an example, consider a 10% drop from $100, which results in $90. To get back to $100, an increase of 11.11% is needed. The difference between these percentages is 1.11%. Now consider a more significant drop of 30% from $100 which results in $70. To get back to $100 a gain of 42% is needed. The difference between 30% and 42% is a much larger 12%.

Drop | Gain to Recover | Difference |

1% | 1.0101% | 0.0101% |

3% | 3.0928% | 0.0928% |

10% | 11.111% | 1.111% |

30% | 42.86% | 12.86% |

30% (3x ETF) |
33.333% (3x the 1x ETF) |
3.333% (9.5% missing!) |

For a non-leveraged ETF, this does not mean much. But for a leveraged ETF, the fundamental problem of leveraged decay arises from the fact that as daily percent changes are increased due to leverage, the gain percentages are not enough to make up from the increased loss percentages. The example above proves this point since a 3x ETF drops 30% for an index that drops 10%. When the underlying index gains 11.111% to reach its original value the 3x ETF will increase 33.333% which is not enough for the 3x ETF to reach its original price point.

**Doom and Gloom: Bearish ETFs**

While there are some positive aspects of bearish ETFs which will be covered in future posts, the math is unfortunately set up against them. As we have seen previously, a repeated pattern of a 1x ETF of -10% and +11.11% results in the 3x bull ETF moving -30% and +33.33%. The bear does the opposite which is +30% and -33.33%.

Bull 3x: -30%, +33.33% (+3.33 extra percentage points)

Bear 3x: +30%, -33.33% (-3.33 extra percentage points)

Leveraged bear ETFs not only suffer from decay, but they also suffer from point #5 which means in a horizontal market the bear ETFs are always moving down by greater percentages than the percentages they move up. If the market turns into a bull market, or even moves sideways, bear ETFs are a one way ticket to zero. Only a market that continually moves downwards can sustain leveraged bear ETFs. This has significant implications for long term holders. Anyone that has a long term hedge position in a leveraged bear ETF has both decay and loss percentages working against them. A chart of 6% daily moves for a 1x index over 30 days (15 oscillations of -6% then +6.4% for the 1x ETF, resulting in -18% then +19.2% for the 3x bull ETF and +18% then -19.2% for the 3x bear ETF) shows the bear ETF getting destroyed compared to the bull:

**Hypothetical Long Term 3x ETF performance**

To get an idea of how 3x bull and bear ETF might perform (excluding fees and other costs), this is a chart showing IWM (Russell 2000) during the bear market of 2000 to 2003:

ETF | % Gain |

IWM | -36% |

IWM 3x Bull | -84% |

IWM 3x Bear | +44% |

For the bull market of 2003 to 2007:

ETF | % Gain |

IWM | 149% |

IWM 3x Bull | 941% |

IWM 3x Bear | -97% |

This is a good example that demonstrates that 3x bull ETFs are not going to 0, provided there is enough upward trend in the underlying index to offset loss due to decay.

### Essential Links

Trend, Volatility, and Returns – A must read study that goes more in depth on leveraged decay, but also covers other aspects such as compounding. Written by Connors Research, (the research division of The Connors Group) which is part of a network of sites such as TradingMarkets.com.

Direxion Literature – A fantastic set of 5 articles describing the ins and outs and risks of leveraged ETFs.

Understanding ProShares’ Long Term Performance – A 2-page document that has a simple explanation of the relationship between compounding and volatility in leveraged ETFs.

On-Demand Webinar: Getting Leverage, Going Short – A must watch webinar that covers the history of Leveraged ETFs, an overview of how they work, and information on their tracking properties. Written by Matt Hougan, editor of IndexUniverse.com. The link includes a PDF of the slides if you do not want to watch the video.

**Conclusion**

This post covered the reasons for leveraged decay and the factors that influence the amount of loss due to decay. However, there are many other aspects to decay and leveraged ETFs that will be covered in future posts. Here is a peek at some topics that will be covered:

- Margin vs Leveraged ETFs
- Leveraged ETFs and Compounding
- Decay vs Trends
- Measuring Leveraged ETF decay
- Advantages of Leveraged Bear ETFs
- Advantages of Leveraged Bull ETFs

I love this topic! I really enjoyed reading this. I have tried explaining this concept to so many people but they leave with the most puzzled look ever.

I’m worried though – I’ve been employing this strategy since early april and only profited about 13% – which is still fantastic but below the monthly average of 20-25% we’ve been seeing since inception.

Can you post an analysis about potential downsides of this strategy and what it would take to lose?

Also perhaps in another post you could post the logistics of utilizing this strategy with puts. (I’ve heard this is a better way of going about it)

Well written article which should be clear to even the most math challenged.

Hi Kevin!

Thanks for reading and commenting on my website. Very nice post, with a thorough analysis of the fundamental structure of leveraged ETFs. It was a good idea to point out the difference between Bull and Bear in a flat market.

One small note though: A flat market assumes that the index over time is flat, and I believe that this is what you have simulated. However, you´re writing “A chart of 6% daily moves over 30 days shows the bear ETF getting destroyed compared to the bull:”. The daily moves downwards need, as you have pointed out earlier, to be smaller (in %) than the gains, namely in your case of a 6% increase (1-100/106)=5,66%.

This aspect, that the percent loss is smaller than the gain when the market is flat, explains the difference between the Bull and the Bear leveraged ETF.

Peter, thanks for the heads up. I think I just need to improve the wording in the article. I will update it with the changes.

Great analysis, although I think there is a little more going on behind the scenes. As you’ve noted, a 10% downward move takes an 11.1% upward move to get back to breakeven.

However, you take the assertion that these ETFs will double (or triple) the daily index move at face value.

In fact, there will be an asymmetry between the costs of leveraging 3x up and 3x down. ETFs tend to use derivatives to achieve their leverage, but the effect is the same, and easier to illustrate, if you just use a margin account.

To get 3x upwards leverage, you need to borrow 2x your portfolio to buy 3x the index. For the sake of simplicity, assume you can do this at the 3-month T-Bill rate, which is very low right now, but longer-term should probably be between 2% and 3%. This means that there will be an annual drag of two times this interest rate, or 4% to 6% on a 3x bull fund.

Conversely, if you are short 3x leverage, this means that have shorted 3x your originial investment, which means that you have 4x your investment to put into T-Bills, making 8% to 12% a year.

This is more than just theoretical, this same asymmetical difference between leveraged long and leveraged short positions is present in the derivatives that the ETFs use to get their leverage. If this wasn’t true, than what is stopping you from shorting every leveraged bear ETF and getting rich? Even if you can’t get a locate, you could just duplicate their investment strategy, and short that (basically take the other side of the leveraged bear ETF derivative trades).

Regardless, I am happy that people are finally realizing that these are very bad long-term investment vehicles. If you want 2x leverage, just do it on your own in a margin account, and save yourself some decay.

Adrian,

I don’t dispute a single thing you said in your well written comment. I originally had a disclaimer in the article to mention that it does not cover losses due to the underlying fees and instruments. This article basically just covers the math behind decay of hypothetically perfect leveraged ETFs.

Kevin

A very well written and article and website. However, you only gave an example of a leveraged etf decreasing over a number of days. I would be grateful if you would provide a simiar example of a leveraged etf rising over consecutive days. Surely this is where the advantage is?

Cheers

sat

Sat, thanks for the compliments. In a later article I plan to cover what happens to leveraged ETFs when they trend up, down, and for both the bull and bear. I think you will find the results very interesting, and yes there are some big advantages.

I’ve bookmarked this: you can’t get too much coverage of a subject that can make or lose you a lot of money! I trade these leveraged ETF, and have learned to be cautious, but it is so easy to get whipsawed by a freak or unexpected market turn. No one should deal in these unless they can walk away from their stake without tears.

Kevin, Great article! Thank you for taking the time to write this. I have bookmarked this website and look forward to more of your articles.

Very well written. Just a couple of minor points.

First, if you’re going to talk about “decay” I think it’s helpful to specify, relative to what. That’s because even the unleveraged underlying ETF has a form of decay, in the following sense:

Let m be the mean daily relative increase in the unleveraged ETF over a long time period is some quantity m (e.g. m = .0003 if the average is a 0.03% increase, which would be about 7.9% per year when annualized over 250 trading days.)

Let the volatility be s (the standard deviation, e.g. s = .01 if the typical daily change is 1%.)

Then the rate r at which the unleveraged ETF compounds over time is not .0003 per day (= 7.9% per year). It is less; the formula is r = m – s^2/2. If s = .01 then the ETF will compound at r = .0002 per day, or about 5.1% annualized. So the s^2/2 in the formula for r can be viewed as “decay.”

For a leveraged ETF, the rate of compounding over time is as follows:

2x ETF: 2m – 2s^2

-2x ETF: -2m – 2s^2

3x ETF: 3m – 9s^2/2

-3x ETF: -3m – 9s^2/2

When you talk about decay of the leveraged ETF, there are at least two natural ways to measure it. For the 3x ETF, for example, one could say that the decay relative to the average m is 9s^2/2, or one could say that the decay relative to the “ideal” growth rate of 3r is 3s^2. It appears from your table that you are measuring decay relative to the ideal growth rate of 3r (for a 3x ETF.)

Another small point: you state that “the loss from decay grows exponentially as the daily percent change increases.” In fact this loss is proportional to the square of the volatility, i.e. to s^2, so it’s not actually exponential.

Ken,

Thanks for the lesson! My latest article covers a way to measure the decay:

http://blog.quantumfading.com/2009/07/12/measuring-leveraged-etf-decay/

Unfortunately, an equation for calculating decay is difficult because Leveraged ETFs are path dependant on the underlying index. I think the equations only work if the underlying index is oscillating the same way each time (such as +/-3% each day).

Make your own ETFs and leverage them 3x.

Start with a million dollars and make two opposing ETFs.

ETF A (long 3x) – Put half a million dollars into the 30 stocks in the Dow weighted correctly. Buy exactly twice the same stocks and amounts with another half million on margin.

ETF B (short 3x) – Put one-and-ahalf a million dollars into shorting the same 30 stocks weighted the same way at the same prices as ETF A.

You now have a long and a short ETF leveraged 3x for the Dow 30.

The first day, as in your example, the market goes down 10%, so the 3x ETFs move 30%.

ETF A loses from $1,000,000 gross and $500,000 net to $700,000 gross and $200,000 net.

ETF B gains from $1,000,000 gross and $500,000 net to $1,300,000 gross and $800,000 net.

You still have your starting million dollars, which used to be $500,000 plus $500,000 and has become $200,000 plus $800,000.

The second day, as in your example, the market goes up 11.1% (1/9).

For illustration, assume no abnormalities and all 30 stocks return to exactly where they started in this illustration.

ETF A gains from $900,000 gross to $1,000,000 gross and $500,000 net.

ETF B loses from $1,100,000 to $1,000,000 gross and $500,000 net.

You still have the same million dollars.

But wait. You say ETF B does not return to $1,000,000 gross and returns only as far as $930,000. Yet in the real world when stocks move up and down then return to where they started, the original holdings, no matter whether long, short or leveraged, are unfazed.

Where did the decay go? Did some-one take part of our million dollars overnight?

Excuse the typos. The second day numbers should be:

ETF A gains from $700,000 gross to $1,000,000 gross and $500,000 net.

ETF B loses from $1,300,000 gross to $1,000,000 gross and $500,000 net.

In the real world, not theory, when stocks rise and fall right back to where they started, your holdings remain the same. Your triple long is worth the same, your triple short is worth the same.

So where and how does your ETF lose money? Who gets the money?

Margaret,

There is no decay with normal ETFs or with margin. The decay is missing because margin is a multiple (such as 3x) over an unlimited timespan. A margin account will get you exactly the desired ratio that is seeked, and it will do it for the life of the holding.

However, leveraged ETFs track an index on a daily basis. Because this tracking is on a daily basis, it does not track for periods longer than a day. The result is decay. This decay exists for any system (it does not have to be stocks) that tracks something else at a multiple for a limited period. It is just due to the math. Even if leveraged ETFs tracked indexes on a monthly timeframe, over a yearly timeframe there would be 12 periods for decay. Such an ETF would decay much less than something tracking on a shorter timeframe like the daily ones today.

Hope this helps,

Kevin

I am unable to construct a viable example where decay applies to stocks or an ETF, as I am unable to define “leveraged ETFs track an index on a daily basis”. Where can I go to see how an ETF manages to track on a daily basis and lose money? By knowing how and why it happens, I can profit on the other side of their loss.

Of approximately 800 ETFs, approximately 700 list their holdings regularly, most of them every day. Leveraged ETFs are among the exceptions that do not want you to know their holdings, buys, and sells. Leveraged ETFs also tend to decline over time. No explanations tell us why no other portfolio declines as your described leveraged ETFs decline. If I create a leveraged ETF on paper, it does not decline. People who run leveraged ETFs that decline almost daily are hiding something, obviously. What are they hiding and how do we invest to profit from it?

Put another way, leveraged ETFs do not decay without meddling with their portfolios daily, as you noted above. A leveraged ETF that stays static is like any-body’s portfolio. So why meddle with the contents of a leveraged ETF? There appears to be no valid and honest point in doing so.

Leveraged ETFs that decay look like Bernie Madoff’s style of work.

Any instrument, anything at all (it does not have to be an ETF, a stock, or anything financial), anything that tracks something else on a daily basis by an increased multiple, such as 2x or 3x, will decay.

Regardless of what leveraged ETFs buy and hold, the decay is from simple math. Leveraged ETFs often track an index. A index is typically made up of a basket of stocks. Please read the prospectus of the leveraged ETFs, your answers are in there.

Regular ETFs and stocks do not decline because they are not tracking something else. It is as basic as that.

If you create a leveraged ETF on paper, something that tracks something else on a daily basis by a multiple such as 2x or 3x, it will decay.

If regular ETFs and stocks do not decline because they are not tracking something else, and it is as basic as that, then you say SPY and SH, which track S&P 500 long and short respectively, do not decline?

I will help you write your next piece, thought by thought. Today’s thought is regular ETFs do decline even though you think they should not.

For illustration, use S%P 500 and its ETFs SPY and SH. SH is the newest, beginning trading on 22 June, 2006. On that day, S&P closed at 1245.60, SPY at $117.30, and SH at $56.25.

If you bought equal amounts of SPY and SH on that day and held them until today,

S&P went down from 1245.60 to 954.07, a loss of 23.40%.

You would expect SPY to have lost the same 23.40% and SH to have gained the same.

SPY went down from $117.30 to $95.55, a loss of 18.54%. SPY beat its index.

SH went up from $56.25 to $63.02, a gain of only 12.04%. SH fared poorly.

Your investment of equal amounts in SPY and SH, which being one short and one long should net zero if you are correct regular ETFs do not decline, declined 8.63%.

The first day’s lesson is that assuming regular ETFs do not decline without looking at them is an unfounded assumption. They do appear to decline.

The next lesson will show regular ETFs do not really decline, but they do move with the index and only appear to decline when the index goes down. What do you assume they do when the index goes up?

All inverse ETFs are affected by decay. Regular ETFs are not affected by decay, but they do have performance characteristics, fees, and expenses. These may cause a regular ETF to be higher or lower than the index they track.

The decay explains why SH did poorly in your example. And, I do not know where you got your data but for June 22, 2006 SPY closed at 124.46 acording to my data. That puts it right in line with the S&P 500.

To clarify my earlier statement… non leveraged bull ETFs are not affected by decay, but they are affected by performance, fees, and expenses.

Hope this helps,

Kevin

Before we get to lesson number 2, I see the need to insert lesson number one and a half.

You will get more accurate results if you look at easily available information and factor it in.

Your June 22, 2006, reference to SPY closing at 124.46 is one of several numbers you will find published, but which is not accurate if you intend to use it to make money. Use these numbers to correct the closing quote you found:

19-Jun-09 $0.518 Dividend

20-Mar-09 $0.561 Dividend

19-Dec-08 $0.719 Dividend

19-Sep-08 $0.691 Dividend

20-Jun-08 $0.669 Dividend

20-Mar-08 $0.642 Dividend

21-Dec-07 $0.775 Dividend

21-Sep-07 $0.719 Dividend

15-Jun-07 $0.656 Dividend

16-Mar-07 $0.551 Dividend

15-Sep-06 $0.579 Dividend

I am gobsmacked by your assertion, “All inverse ETFs are affected by decay. Regular ETFs are not affected by decay.” Using accurate data in later lessons, you will be able to clarify that statement too.

From your statements, “These may cause a regular ETF to be higher or lower than the index they track,” and “they are affected by performance,” I take it your answer is you assume ETFs not only decline when the index goes down, they rise when the index goes up. If so, fair dinkum. Map a few and I am sure you will be surprised at what you see.

I guess I will clarify a bit more :)

When I speak of decay, I am referring to decay that is the result of ETFs tracking price changes on the daily basis, which includes the following types of ETFs:

2x Bull (SSO)

3x Bull (UPRO)

1x Bear (SH)

2x Bear (SDS)

3x Bear (SPXU)

These are affected by the aforementioned decay due to their investment goals which have a timeframe of one day. Non-leveraged bull ETFs that do not have a daily target for tracking purposes are not affected by this type of decay since their timeframe is not on a daily basis. They may be affected by ‘decay’ or ‘losses’ or ‘poor tracking’ or any other name you can think of, but that is due to a variety of factors that affect all ETFs such as dividends, fees, expenses, etc.

I do not claim that any and all non leveraged bull ETF will properly track its corresponding index. That, as you would agree, would be absurd. However. some do a great job, and perhaps some do not.

I just argue that any leveraged ETF or bear ETF that tracks on a daily basis, is affected by decay.

Kevin,

This decay of which you write would happen to a fund that has assets, such as SSO that owns stocks and related paper. As I gather from your input, with notable exceptions it loses value everyday until eventually it reaches its lower limit of granularity, one penny, and stays there.

In order to profit from something like this, I could short leveraged ETFs. Not counting a few apparently highly mismanaged funds, such as RAS and RAZ, history shows I would do better shorting the index or going long the index. However, going long or short an index has inherent risk of market or index reversal.

If SSO is decaying everyday, assets do not disappear into thin air. Not counting unusual circumstances, it is obvious some-one on the other end is receiving those assets. What I prefer is to be on the other side of leveraged ETF asset losses, the profit side.

Suppose SSO started with a billion dollars in assets at $100 share price and 10 million shares outstanding when S&P was 1000.00. S&P goes down 20% the first day and up 25% the second day to return to 1000.00. SSO would do down to $60 the first day and up to $90 the second day. SSO lost 100 million dollars in assets in those two days while S&P ended where it started.

Where did the 100 million dollars in assets go?

If the 100 million dollars in assets did not go anywhere and SSO still has it, then either the number of shares changed or shareholders selling for $90 would be selling $100 of assets for $90. As the market is not in the habit of selling $100 in assets for $90 stock price and the number of shares do not appear to change, the remaining alternative is that fund managers rebalanced and lost 100 million dollars in assets.

In my first post, I asked, “So where and how does your ETF lose money? Who gets the money?” Unlike ordinary long ETFs, short and leveraged ETFs do not post their portfolios. I want to know where the money goes and how to be on the receiving end.

Margaret

As I asked around, no-one could explain how fund managers lose money to decay. The people I asked were puzzled and asked more people, with not one viable thought emerging. Today, the first wave of trouble has shown itself. UBS has suspended activity in the very funds about which you scribe, except for allowing their clients to sell out. The implication is fraud on a scale exceeded only by Madoff. Wall Street Journal has the news but no analysis. http://online.wsj.com/article/BT-CO-20090727-716219.html

The money that ‘vanishes’ probably has to do with the leveraged ETFs use of derivitives and swaps, of which I do not know enough about for me to comment. I do not think it works in the way you described above in terms of assets and values… but, I am not an expert on how the internals of leveraged ETFs work so take that comment with a grain of salt.

And just to clarify, I do not believe bull leveraged ETFs decay to a penny. They will grow and offset the losses from decay if the underlying index has enough gain and little volatility.

Here is an article that goes deep into the math behind leveraged ETFs: http://www.barclaysglobal.com/secure/repository/publications/usa/ResearchPapers/Leveraged_ETF.pdf

@Margaret Board

Margaret:

Take a chill pill. This has nothing to do with fraud… just math and daily impact of buying high and selling low.

The implication of is inherently obvious, namely that more waves of trouble are predicted. Even I am surprised they already have started. That was only Monday and already Ameriprise and LPL have joined UBS, Smith Barney is ‘reviewing’, and Schwab warned its investors.

Take a chill pill, Pairs Profit? I am hardly an issue, just a single voice with questions. Talk to UBS, Ameriprise, LPL, Smith Barney, and Schwab. They mean so much more than I.

There is not much wriggle room. In order for the stock price to go down, either NAV declines, the number of outstanding shares grows, or there is a disconnect between stock price and NAV. If it does not work this way, what way does it work?

The first subpoena, albeit a minor one, was issued today.

I hope you are right and these ETFs stay in business with high volume long enough I can be the one taking their money everyday. First I have to figure out how and where these ETFs manage to lose money almost everyday so I can be on the profit end of that practice. So far, no-one knows, which is an ugly sign.Margaret,

To shed light on your objective: ” First I have to figure out how and where these ETFs manage to lose money almost everyday so I can be on the profit end of that practice. So far, no-one knows, which is an ugly sign.”

Here’s the deal. Leveraged ETFs create daily leverage by investing in futures contracts & credit swaps. If you are not familiar with these subjects, read into the nature of derivatives (which include options, futures, credit swaps, etc). The ETF fund managers purchase derivatives with high specificity to maximize correlation to the underlying index.

Who profits from this transaction? The seller of the derivative. There are three articles below which explain derivatives, the nature of leveraged ETFs, and some potential investment strategies. These investment vehicles (underlying derivatives) are highly speculative and require a lot of research and “trial-runs” before executing any strategies, many of which are complex yet effective. The “lost” money is a result of the volatility created by the derivative.

Kevin is spot-on about the mathematical decay behind leveraged ETFs. Within any given period > 1 day, the greater the volatility, the greater the decay. If the market trends in one particular direction, the respective ETF (bear or bull) will experience a greater magnitude of gain/loss. The best investment strategy? Understand these animals, create a hedged strategy, run some trials with smaller amounts of capital (2% of your investment capital) and decipher the trading patterns (both of yours & the market) before investing with significant amounts of capital.

Overview of Derivatives

http://invest-faq.com/cbc/deriv-basics.html

Operational side of Leveraged ETFs

http://www.etftrends.com/2009/01/how-short-leveraged-etfs-work.html

Investing strategies for leveraged ETFs

http://www.optionsatoz.com/leveragedETFs.aspx