Too many people are making sucker bets with these products.
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By Paul Justice, CFA | 01-22-09 | 12:13 PM | Email Article

The Curious Case of Google
Just as we know that no real world indexes go only straight up, we also know that many don't have each up day followed by an equal but opposite down day. So here's another example:  Google , which was an instant sensation when it went public in August 2004. Let's pretend that you were not smart enough to get in on the IPO date, but you jumped on the Google bandwagon instead on Jan. 3, 2005, at the market closing price of $202.71. You would have been euphoric until Nov. 6, 2007, when the stock closed at $741.95. At this point, you're ready to declare yourself a stock market genius and ponder buying a modestly sized sailboat, which you'll name "Market Timer." Alas, you fail to pull the sell trigger that day, and you proceed to hold on to Google until the end of 2008, where the stock closes at $307.65. At this point, you'll refrain from writing your investing biography, but you're content enough with your 52% return given that the S&P 500 has done nothing but nosedive.

Paul Justice, CFA, is director of fund research methodology for Morningstar.

Let's also pretend that you're more than willing to share your market insights with your hyper-competitive brother-in-law. You let him know about your Google purchase the moment you pull the trigger, and he jumps at your idea. However, he's crafty. He finds an obscure ETF that promises double the daily returns of Google for a low 0.75% per year fee. Fast forward to Google's high in November 2007. While you're delighted that your sister will be well provided for, his non-stop bragging about his 677% return is driving you nuts. You're thinking about getting a recreational boat, and he's boasting that you can dock it at the lake house he's going to buy. And this jerk's doing it with your idea.

Alas, once he hears that you're not ready to sell, neither is he. When the two of you meet up again for New Years 2009, he's fuming because he's not only given back his gains, he's actually lost 2% of his initial investment. That's right, you're up 52% and he's lost money. You'd like to smirk, but your poor sister is married to this knucklehead. To add insult to injury, you have to pick up the tab at the end of night because he's broke. He would have had to not only capitalize on your investment idea, but also mimic your execution in order to have been positive. Compounding returns strike again.

Here's my last example. If you've already wrapped your arms around the concept, please skip to the next section. This time around, I'll use a pretty little table to illustrate my point.

 
Month
Crude Oil
Index
Traditional
Single Long
ETN
Single
Short
ETN
Double
Long
ETN
Double
Short
ETN
Triple
Long
ETN
Triple
Short
ETN
0 35 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00
1 40 $114.25 $85.68 $128.53 $71.39 $142.82 $57.11
2 45 $128.49 $74.94 $160.62 $53.52 $196.33 $35.67
3 50 $142.72 $66.58 $196.26 $41.61 $261.70 $23.77
4 55 $156.94 $59.90 $235.44 $33.27 $340.11 $16.63
5 60 $171.15 $54.43 $278.16 $27.21 $432.74 $12.09
6 65 $185.35 $49.88 $324.41 $22.66 $545.77 $9.06
7 60 $171.02 $53.70 $274.38 $26.14 $415.78 $11.15
8 55 $156.71 $58.15 $228.55 $30.49 $311.68 $13.93
9 50 $142.40 $63.42 $186.91 $36.02 $226.56 $17.73
10 45 $128.11 $69.73 $149.46 $43.21 $158.51 $23.04
11 40 $113.83 $77.46 $116.19 $52.80 $105.62 $30.71
12 35 $99.56 $87.11 $87.10 $65.98 $65.97 $42.21
Annual Return   -0.44% -12.90% -12.89% -34.02% -34.02% -57.79%

I've constructed an imaginary fund that delivers twice the monthly returns on a barrel of crude oil, charges an annual fee of 0.75%, and pays interest at the T-Bill rate of 0.30%. If you're curious, this is very similar to  PowerShares DB Crude Oil Double Long ETN . Let's say oil is priced at $35 today, and the price is going to go up by $5 every month for the next six months. After six months, you'd be delighted to see that your initial $100 investment had grown to around $325, which is even greater than twice the promised return. The reason the fund would have gained 225% up to this point is that there was no single downtick: It was a perfectly straight upward trend. This is an event that very rarely happens in reality over long periods of time. One of the only examples I've been able to find that exhibited this behavior was the Fairfield Sentry fund. That was managed by one Bernie Madoff, and it turns out those returns weren't so real after all.

Back to our example. Now let's assume that the good times are over, and over the next six months, oil goes down by $5 per barrel per month. It then ends the year exactly where you started, at $35. Due to the disappointing mathematics of the volatility drag, you would lose around 13% of your original investment, thanks to the fund's leverage and compounding. Oddly enough, the single-short ETN (betting against the index but without leverage) has the same return profile as the double-long ETN. Furthermore, the returns grow more negative with each successive layer of leverage employed.

So Why Are We More Concerned Today?
In November 2008, Direxion released the first slate of triple-leveraged exchange-traded funds, and the market welcomed them with open arms. In a matter of weeks, the suit of 14 ETFs attracted more than $1 billion in assets, and the firm has expedited the issuance of similarly structured funds.

I think that making 300% bull and bear funds available is good thing for the ETF market--but that doesn't mean it's right for you and me. I am not blaming the institutions that sponsor these funds. They've been very forthright about disclosing the potential shortcomings of these products. The ETF structure is well-suited to house these types of instruments, and there are a few legitimate uses for these funds (mainly for people who manage large sums of money). Any investor that takes the time to thoroughly read and comprehend the prospectus will realize that, when held for anything longer than a few days, the deck is stacked against them under most market conditions.

Here's an example of who could potentially use these funds. Let's say that you're a diversified large-cap mutual fund manager that is facing redemptions. You're going to have to liquidate several holdings, but you don't want to lose your exposure to the market. You could purchase a slug of these leveraged funds in the morning, sell three times that amount of your other holdings to raise cash, and then sell the leveraged fund at the market's close. You would have maintained your market exposure for the day without having to rush at the market's close to dump some holdings.

Another use for these funds is for short-term speculation. If you're inclined to bet--not invest, I said bet--as to what a sector or index is going to do over the course of a day or two, go ahead and use these funds. Good luck. I've never met an investor who can consistently execute this strategy (though I've met plenty who claim they can).

Perhaps investors have been lulled into complacency. After all, most ETFs are extremely transparent, have rock-bottom fees, are extremely liquid, and track their respective indexes in virtual unison. The traditional unleveraged products have worked so well at tracking indexes that perhaps prospectus reading seems like an unnecessary burden. I hope this is not how some investors have evolved, but the asset flows are leading me to believe otherwise.

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Morningstar - 2009/01/22 - Warning: Leveraged and Inverse ETFs Kill Portfolios--Page 2 - <a href="http://www.morningstar.com/articles/author/615-paul-justice--cfa.aspx">Paul Justice, CFA</a>
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