What Can We Learn From the 2008 Leveraged ETF Collapse? Part 1

Was the ^SSO^ doomed to fail? In this two-part article we will show you why the ETF was and still is flawed, and what we can learn from one of the worst performing investments of the past year that will help us build better investment portfolios and leveraged trading strategies.

2008 was the year that investors were punished for the crimes of others. The value of most broad-based equity indexes fell by more than a third, and the S&P 500 itself was down about 40%. This poor index performance would seem to be all that is needed to explain the dismal performance of the corresponding leveraged ETF.

SSO Chart

In fact, SSO never had a chance. The design of the fund trapped investors into a position in which they were almost guaranteed to lose money over the long term no matter how the S&P 500 performed. The only question was whether the losses would come quickly or slowly.

Read this innocuous fund description: “Ultra S&P 500 ProShares seeks daily investment results, before fees and expenses, which correspond to twice (200%) the daily performance of the S&P 500 Index.” This sounds ideal for an investor looking to double the potential return from an investment dollar, but has two key phrases in plain view that virtually guarantee long-term losses.

The first key phrase is “before fees and expenses”. All funds have expenses that include management fees and transaction costs, but leveraged funds have an additional expense attributable to the cost of capital associated with the increased equity exposure. We can back out the total expense level by analyzing daily returns.

In Table 1 below, we calculate the difference between the daily return of the ProShares Ultra S&P 500 ETF and the doubled daily returns of the ^SPY^. On a daily basis, the ETF provides a return about 2.7 basis points lower than we would expect. That may not sound high, but compounded the result is portfolio sticker shock: 7.1% annually.

SSO daily return Chart

This means that unless the S&P 500 provides an annual return of more than 7.1%, the leveraged ETF will underperform the underlying index. Or that in order for the leveraged ETF to return at least 15% in a single year, the underlying index would have to return 11%. (Add 7, divide by 2.)

While short-term investors may consider this expense just the price of admission, what will be of greater concern is the fund’s tracking error. The standard deviation of the difference between the expected and actual daily return is 58 basis points and on some days as much as 300. This variation just adds more risk to a trader’s position.

The second key phrase is “twice the daily performance”. In a volatile market this can mean huge potential losses that are difficult to recover from. In Table 2, we show a sequence in which the leveraged ETF was brought to the edge of ruin, losing almost half of its value in twelve market days.

SSO daily return Chart

At the end of this period, the S&P 500 has lost 25% of its value and now needs a 33% gain in order to break even. But that won’t be enough for the leveraged ETF, which now demands a 40% gain in the underlying index in order to make up the losses. It takes more effort for the leveraged ETF to recover than the underlying index.

Like the 7.1% expense, this performance penalty isn’t intuitive. Yet it’s simple multiplication. A 25% gain erases a 20% loss, but a 50% gain will not erase a 40% loss. The damage done by doubling negative returns is worse than the benefit gained by doubling positive returns.

Thus the leveraged ETF has taught us two valuable lessons: First, unexpected expenses can wipe out returns over time and significantly lower the breakeven point for an investment, and the best way to find these expenses is by comparing expected returns to actuals. And second, boosting both positive and negative returns can drive a portfolio into a ditch that is just about impossible to climb out of, even if the underlying index does recover.

In part 2 of this article, we will learn how intelligently managing a portfolio’s changing market exposure can boost returns and lower risk, and how to use that technique to build a better leveraged ETF or investment portfolio.

Tristan Yates is the author of Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance and writes articles on index investing, options strategies, and leveraged portfolio management for Investopedia and Futures & Options Trader. He also helped lead the $1T Fannie Mae securities restatement. Yates has an MBA from INSEAD, a leading international business school.

Have You Switched to ConnorsRSI?

ConnorsRSI is the first Quantified Momentum Indicator -- the next-generation improvement to traditional RSI indicators. At Connors Research, we are using it as an overlay to many of our best strategies to make them even better -- now you can, too.

Enter your email address to get your FREE download of our Introduction to ConnorsRSI - 2nd Edition - Trading Strategy Guidebook with newly updated historical results.

Disclaimer: The Connors Group, Inc. ("Company") is not an investment advisory service, nor a registered investment advisor or broker-dealer and does not purport to tell or suggest which securities or currencies customers should buy or sell for themselves. The analysts and employees or affiliates of Company may hold positions in the stocks, currencies or industries discussed here. You understand and acknowledge that there is a very high degree of risk involved in trading securities and/or currencies. The Company, the authors, the publisher, and all affiliates of Company assume no responsibility or liability for your trading and investment results. Factual statements on the Company's website, or in its publications, are made as of the date stated and are subject to change without notice.
It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results of any individual trader or trading system published by Company are not indicative of future returns by that trader or system, and are not indicative of future returns which be realized by you. In addition, the indicators, strategies, columns, articles and all other features of Company's products (collectively, the "Information") are provided for informational and educational purposes only and should not be construed as investment advice. Examples presented on Company's website are for educational purposes only. Such set-ups are not solicitations of any order to buy or sell. Accordingly, you should not rely solely on the Information in making any investment. Rather, you should use the Information only as a starting point for doing additional independent research in order to allow you to form your own opinion regarding investments. You should always check with your licensed financial advisor and tax advisor to determine the suitability of any investment.
HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING AND MAY NOT BE IMPACTED BY BROKERAGE AND OTHER SLIPPAGE FEES. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.

All analyst commentary provided on TradingMarkets.com is provided for educational purposes only. The analysts and employees or affiliates of TradingMarkets.com may hold positions in the stocks or industries discussed here. This information is NOT a recommendation or solicitation to buy or sell any securities. Your use of this and all information contained on TradingMarkets.com is governed by the Terms and Conditions of Use. Please click the link to view those terms. Follow this link to read our Editorial Policy.