Understanding leveraged ETFs

A number of Covestor models use leveraged ETFs as part of their investment strategy. SymmetricInfo has a two-part post illustrating the mechanics of leveraged ETFs that work on a daily return basis, and the potential pitfalls in these securities that not all investors are aware of, despite (in some cases) the ETF provider making a concerted effort to explain how their fund works. While these pieces focus on the recently popular levered short treasury ETFs such as TBT, the mechanics are the same for any such daily return based leveraged ETF.  It’s important reading for anyone considering using these instruments. An excerpt (via Kid Dynamite):

Many investors who are betting on price declines in treasuries are buying levered short ETFs and holding them past one day. When investors do this they are making a highly complex bet on the future path and volatility of the underlying bond index. Therefore if investors want to short treasuries using a levered ETF, they should think through what path they expect treasuries to follow and whether those price declines are likely to take place during a high or low volatility regime.

If  the expected decline in treasuries coincides with higher volatility and/or a higher degree of mean reversion in bond prices (perhaps reflecting short term uncertainty in the market), then holding onto a levered short treasury ETF over that period will likely underperform simply shorting an unlevered bond fund (e.g  TLT equity) using leverage. It is entirely possible that investors who end up being right on the direction of the underlying bond index and would have profited from shorting it, may instead lose money buying a levered short ETF.

Links to the full pieces from Symmetricinfo.org:

Investors in levered short treasury ETFs may be setting themselves up for disasterPart I and Part II

Image: Cesar Rincon