talking point | the blog at LeeHudsonTeslik.com

I’ve written about this before, but I feel it bears  more coverage, and with one notable exception (Izabella Kaminska at the FT) nobody seems to be paying much attention. The ETF market strikes me as incredibly ripe right now for abuse (or confusion, at very least), given public interest in investments that seek leveraged or inverse returns, or both. There is a flood of new synthetic ETFs that might strike retail investors as logical vehicles through which to do this, but they are not what they seem at first blush.

Here’s an example. The following chart from Google Finance shows the S&P 500 index over the past year (the red line), and next to it the ProShares Short S&P500 index over the same period (blue).

An investor buying such a product might logically assume that it would track the inverse of the S&P. You’ll notice in the chart that the S&P is up a little under 10% for these 12 months, so an investor might assume that the ProShares index mapping its inverse would be down roughly 10%. In fact, the ETF is down roughly 30%.

The discrepancy in returns comes, in large part, from how these sorts of ETFs work. Unlike buying a stock, which has a set value correlated to the value of a sliver of a company (i.e. it’s pegged to something that represents actual value, even if what that value is can be disputed), the NAV prices of ETFs are somewhat arbitrary. They “reset” after each trading day, and only seek to track their benchmarks for that day, not over the long-term.

Here’s what this means in practice. Say you buy one share of an ETF for $100/share. The ETF seeks to track the inverse of Stock Index A, which is trading at a NAV value of 100. On the first day, Stock Index A rises 10%, to 110. The ETF, assuming it tracks its daily benchmark perfectly, falls 10%, to $90/share.

Then, on day 2, Stock Index A gains another 10% (or 11 points — 10% of 110). The index closes the day at 121. The ETF, meanwhile, loses 10% of $90, or 9 points, and falls to $81/share.

Now, on the third day of trading, Stock Index A falls to 100. So it lost roughly 17.4% of its value. The ETF tracking the inverse gains the same percentage, or ~17.4%. But 17.4% of $81 is $14.06. So the ETF only rises to $95.06.

Result: The index winds up even after 3 turbulent days of trading. The ETF, however, has lost almost 5% over the same period.

The longer you hold a leveraged or inverse ETF, the more magnified this discrepancy becomes, even if the ETF is executing its daily objectives perfectly.

The key point here is that investors should be aware that these tools are not intended to map the inverse or leveraged returns of their benchmarks over long periods of time. This fact is easily lost on novice investors, particularly given that details about how ETFs actually work do not often play a prominent role in the advertisement of these products.