“Double the risk for double the reward” is how some popular leveraged ETF’s (LETFs) are marketed, or at least perceived. Although the S&P 500 LETF (symbol SSO) is much more volatile than its S&P 500 stock mutual fund (symbol SPY) counterpart, some risk takers feel it’s worth it for the possible added compensation. Are LETF’s attractive investments? Is the SSO’s risk worthwhile?
LETF’s equal more risk for less reward
Those buying LETF (2x leveraged ETF) investments will, for the most part, end up sorely disappointed and a lot poorer. Despite the seemingly logical trade-off —much more risk for much more potential reward —in reality, many of these complex investments have produced minimally added reward despite much greater volatility. From 2007 through 2018, investors in SPY (S&F 500) compounded their money at 7.02%, (growing $10,000 to $22,574) vs. SSO’s 7.71% (growing into $24,379). Although the growth of the LETF was only slightly higher, its downturns during a roller coaster 12-year time period were about twice as bad. (SPY’s worst down periods were -50%, -13% and -8% vs. SSO’s -81%, -27&, -17%, etc.) Enduring twice as much risk for less than 10% added upside is a loser’s bet and the product is being falsely marketed.
The bold letters miss the reality
A closer look at the details of the SSO LETF reveals that it is designed to double, not the long-term ups and downs of the S&P 500, but its day-to-day movement. Although this seems to be a minor distinction, in reality, the math works out in a completely different pattern than intuition would lead one to expect (see next paragraph). Indeed, the prospectus, a disclosure document which most investors unfortunately ignore, includes a helpful chart that shows that in most scenarios, SSO’s long-term positive and negative returns are not neatly doubled as the broker claimed. While they may have some use to a professional trader, amateur users of LETF’s are placing their money in great jeopardy with inaccurate assurances of commensurate reward.
An optional math example
The math-challenged can safely skip this paragraph, but for those who are interested, here’s an illustration of how a short-term doubling doesn’t add up to an equivalent twice as large growth or loss over time. Compare a SPY daily return of +20% followed by -10%, each of which is doubled by SSO to +40% and -20%. The combined return for SPY is +8% vs. SSO +12%, not a doubling as expected to +16% (SPY 100 *1.20 = 120 * 0.9 = 108 vs. SSO 100 * 1.4 = 140 * 0.8 = 112). While a smaller than expected gain is not terrible, consider an admittedly extreme example where SPY lost 30% one day and then gained 43% a day later, and SSO doubles those movements to -60% and then +86%. The math works out to breaking even for SPY while SSO retains a loss of 26%, an infinitely worse return! (SPY 100 * -30 = 70 * 1.43 = 100 vs. SSO 100 * -60 = 40 * 1.86 = 74.4.) Although it’s OK to skip the math in an article, when it comes to your investments, someone has to run the numbers!
Bulls, bears, and something else
Taking on additional risk is only sensible when the potential rewards are proportionate and survivable. Yet, despite the lousy math, some stockbrokers sell 3x LETF’s, which aim to triple the short-term fluctuation of the various funds, to novice investors! Earning phenomenal short-term returns is exciting, but the party will end badly. Amateurs don’t understand that the risks of LETF’s are much higher than advertised, and regardless of the specific form or flavor, most will come to regret owning them. Wall Street has its confident “bulls,” who are always positive and charging ahead, and the pessimistic “bears,” who are consistently preparing for winter and hibernation. The old saying goes, however, that while “bulls make money and bears make money, pigs get slaughtered.”