Image Credit: Christophe Vorlet
By Jason Zweig | May 19, 2017 9:08 am ET
Volatility is back — but the latest way of trying to make money off it is wildly risky.
Until this past Wednesday, the S&P 500 had gone for 15 days in a row without moving up or down by more than 0.5% — the longest such streak, according to WSJ Market Data Group, since February 1969. Then the index snapped down 1.8% on the political turmoil in Washington.
At the same time, the Securities and Exchange Commission is reconsidering its approval of a pair of exchange-traded funds that would seek to quadruple the daily returns on U.S. stocks. That decision isn’t expected right away. But a closer look at these funds shows how easy it is for investors to get scorched when they play with fire — and how hard it still can be to get the information you need on risk.
These funds, called ForceShares Daily 4X US Market Futures, come in two versions, each betting on financial contracts whose returns are tied to those of the stock market. The long fund seeks to deliver four times the daily performance of those futures; the short fund, four times the opposite.
Thus, on a day when S&P 500 futures were up 1%, the long fund would gain approximately 4% and the short fund would lose about 4%. On a 1% down day, the long fund would lose roughly 4% and the short fund would gain about the same amount.
How risky is that over time?
Not very, if you go by the disclosures in ForceShares’ offering document, which are the equivalent of a shrug emoji.
There, three tables show how the funds might perform. Remarkably, two of those tables assume that the market doesn’t fluctuate at all. In one, stocks go up exactly 0.14% every day over the 20-day period; in another, they go down by that identical amount each day.
A third table assumes that stocks fluctuate at an annual rate of 12.54%, significantly lower than the 14.28% cited elsewhere in the ForceShares document for the five years ended in December 2015.
The maximum loss shown in these tables is less than 11%, although the prospectus does warn that the funds aren’t suitable for long-term holders and “you could incur a partial or total loss of your investment.”
Kris Wallace, principal executive officer of ForceShares, declined to comment on any aspect of the filing. A spokeswoman for the SEC also declined to comment.
But markets are rarely as calm as these disclosures imply.
William Trainor, a finance professor at East Tennessee State University, has been researching leveraged funds for years. I asked him to estimate the returns the ForceFunds would generate over a full year.
If the S&P 500 falls between 18% and 22% in a year, a quadruple long fund would lose an average of about 60% even if stock prices declined in a smoother pattern than the historical average, says Prof. Trainor. If prices bounce around even more sharply on the way down, the fund could lose about 70%. A 4X short fund would produce comparable losses in a similarly rising market, his analysis shows.
That’s not all. These funds can lose money even if the market goes nowhere.
Pauline Shum-Nolan, a finance professor at York University in Toronto, calculates that even in a year when the stock market fluctuates normally but ends up delivering an annual return of zero, a quadruple long fund could lose 11.4%, and a quadruple short fund 18.4%.
While such funds might be suitable for short-term traders, says Prof. Trainor, “over periods of six months to a year you should expect to have most of your wealth disappear, especially in the quadruple-short variety.
Why do the returns of so-called leveraged ETFs deviate so sharply over longer periods from the performance of their benchmarks?
Say you put $10,000 in both the S&P 500 and a 4X long fund tied to it. If the market rises 10% today, your S&P investment would gain $1,000, so you now have $11,000 there. And the leveraged fund would gain four times as much, turning $10,000 into $14,000.
Now let’s assume that the S&P 500 falls 9.1% the next day. Your investment in the index would fall by $1,000, leaving you with $10,000, right back where you started. Meanwhile, the 4X fund would quadruple that loss, for a decline of 36.4%. That would knock your $14,000 down to just over $8,900. (For simplicity, we’re ignoring the effect of fees.)
The longer you hold such a fund and the more stocks fluctuate, the more its returns will differ from a simple quadrupling of the market.
All told, leveraged and inverse ETFs have a combined $43.6 billion in assets, according to ETF.com. If speculators want to double, triple or even quadruple their bets, well, it’s a free country. But they should, at the very least, get clear disclosures that enable them to understand the risks they’re running.
Source: The Wall Street Journal, http://on.wsj.com/2pSIoff
Resources:
Chapter Eleven, “What Makes Ultra ETFs Mega-Dangerous,” in The Little Book of Safe Money
Definitions of EXCHANGE-TRADED FUND and LEVERAGE in The Devil’s Financial Dictionary
Matt Hougan, “How Long Can You Hold Leveraged ETFs?”
William J. Trainor Jr. and Edward A. Baryla, Jr., “Leveraged ETFs: A Risky Double that Doesn’t Multiply by Two”
Rodney Sullivan, “The Pitfalls of Leveraged and Inverse ETFs”
Marco Avellaneda and Stanley Zhang, “Path-Dependence of Leveraged ETF Returns”