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Is There a Right Way to Use a Leveraged or Inverse ETF?

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar.

It's ETF Investing Week on Morningstar.com, and today we are answering your ETF questions.

I'm talking with Paul Justice; he is director of North American research for ETFs. He's going to talk about leverage and inverse funds. These are funds that created a few headlines recently about whether they are good investments at all. We're going to ask today, is there any use for these funds and how can you use them in a smart way, if you are going to use them?

Thanks for joining me, Paul.

Paul Justice: Thanks for having me.

Stipp: So, you folks talked about these funds at length recently, talked about why you have to use them carefully and why they perform in ways that people don't expect.

Before we talk about how you might use these in a smart way, can we talk about these investments don't perform the way people expect them to perform and why people get into somewhat of a trap with them because of the way that they are using them?

Justice: Sure. Well first, you can look at the data: Any leveraged ETF that's been around since Jan. 1 of 2008 or before has a loss, and there were 23 up funds and 23 down (inverse) funds. So, for all those to have a loss, there has got to be some sort of issue going on if indexes are going to move in any direction. That issue is a volatility drag: Whenever there is volatility in the market, which we had heightened volatility for a long period of time, it will cause both double-long and double-short funds, potentially, to lose money, no matter which way the index goes.

So, that's an issue that people need to aware of. It's an expectation error, where they see this phrase of two times or ... three times long or short, and they expect that, no matter when they purchase that fund, when they sell it, if it's one day or one year later, they have this mentality, they expect to get that multiplier. That's not the case at all. You look in that fund's prospectus, and it defines what kind of timeframe you should get that exposure.

Stipp: So, the timeframe is important because these funds do say that they are going to do an inverse, they do say that they are going to give double exposure. Do they actually deliver it over any time period then?

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Justice: They generally perform extremely well over the stated timeframe, which is generally one day for almost all funds, and then some of the commodity funds and others do have a month-long period. But for the most part, day-in and day-out for that one-day period, they track extremely well.

Stipp: So, one day investing is something that's beyond the realm, I think, of a lot of people out there. They don't think about, where I'm going to put my money today, and I think especially Morningstar readers don't necessarily think that way.

Is there a way to use these funds over a longer period of time, if you thought that you needed to have or wanted to have one of these funds, where you can adjust for this one day time period?

Justice: Certainly. They wouldn't be around if there wasn't a legitimate use for them. We do caution strongly against some individual investors, who don't have the time to trade in their account every single day to use these funds. These are very hands-on approach to fund management.

But if you are an institution, and you are really looking to get some exposure say, you have transition management or people sold out your funds, but you want to maintain market exposure, so you're going to put that cash to work for that one-day period, leverage funds make a lot of sense in that case, or if you are a very speculative short-term trader, and you've got some sort of move that you expect to happen in a couple of days, these are an effective way to get exposure.

The reason being, first, they are extremely liquid, they are broadly traded, they cover lots of sectors, lots of broad indices. So, you can get in and out these positions very easily without really having a disruptive cost.

Second, oftentimes, the leveraged ETF is going to give you exposure to things that there may or may not be substitutes, like futures markets, available in some of these sub-sectors where ETF have proliferated. So, it gives an institution this opportunity to get targeted exposure in an area where a futures market or spot market will be cost prohibitive.

I think the third way is that, leveraged ETF are generally going to give the purchasers, the individuals, the advisors, they are going to give you an extremely low institutional-type interest rate on the borrowings. Whenever you have a leveraged fund, you ... basically have to borrow from somebody else to get two times the exposure.

If you were to do that in a margin account, that can be an extremely high interest rate; 7%-8% wouldn't be uncommon in a brokerage account. Whereas if you look at swap interest rates in the market, I mean they are extremely low especially over a short period of time. It could be almost negligible over the course of the year right now. So, I think that's one good use.

I would say, if somebody chooses to use these funds, they really want to get that exposure, the key is, that they do have to look at the funds and rebalance them every day because after one day, if you've got a two times long fund, and you're actually right, that index goes up 1% or 2%, you're actually going to have a much large position in that fund, and your second day exposure is also going to get two times return. So, it could magnify very quickly.

So, after it goes up, you should be taking some money off the table on that position, or conversely if it was going down, you'd have to add money to that position. So, it can be quite tax inefficient, if you are going to be going through that approach.

Stipp: So, as with any investment, you really need to know what these funds are doing. They are performing as they are saying they are going to perform. They could have some very specific uses, particularly as you said, for some institutional investors, but certainly if you are looking at one of these funds, make sure you know how it operates, make sure you know how you are going to use it, and set the right expectations.

Justice: Exactly. People like to envision that they are sophisticated, educated investors, but give yourself realistic assessment of not only your intellectual capabilities, but your time commitment, how willing you are to watch that and trade that thing very frequently--otherwise you can get whip-side very quickly.

Stipp: All right Paul, well it sounds like certainly an investment that you should handle with care, you should dig into before you consider. Thanks for the tips and for joining me today.

Justice: My pleasure. Thank you.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.