2X and 3X ETFs Are Not The Best Long-Term Hedges

As active investors continue to watch their portfolios fall, it is natural for even traditional buy-and-hold investors to not only consider liquidating existing positions, but also think about ways to hedge their portfolio (or even profit from the relentless downward trend). Since the easy short money has probably already been made, some investors and traders are turning to 2X and 3X inverse or short ETFs to juice returns. While such ETFs have been in existence for a while, and articles detailing the uses and pitfalls have surfaced (see two recent 2009 WSJ articles here and here), it is still worth reminding investors how double, triple, and inverse ETFs are better suited for day traders, and are not perfect tracking vehicles past one day. The reason for this is that with the right type of daily moves over an extended period of time, compounding errors can result in inverse ETFs generating overall losses, even when the reference index is down considerably. Tom Lauricella's WSJ article outlines why:

"For example, take a double-leveraged fund with a net asset value of $100. It tracks an index that starts at 100 and that goes up 5% one day and then falls 10% the next day. Over that two-day period, the index falls 5.5% (climbing to 105, and then falling to 94.5). While an investor might expect the fund to fall by twice as much, or 11%, over that two-day period, it actually falls further -- 12%. Here's why: On the first day, doubling the index's 5% gain pushes the fund's NAV to $110. Then, the next day, when the index falls 10%, the fund NAV drops 20%, to $88."

So while a 2X short ETF will double your daily returns when the associated index is down by X, holding periods longer than one day are subject to compounding variations. Unfortunately, such compounding effects may not be the only surprise for long-term investors of index ETFs, or even those with shorter holding periods. Investors need to fully understand what is being tracked. For instance, the popular USO ETF actually trades based on crude oil futures, and not the spot price of crude. As such, if futures prices do not increase as much as the spot price, your ETF may end up gaining less than expected. Rolling from one contract month to the next could also cause gains or losses. If the crude oil futures market is in contango (futures trading for more than spot), rolling over the futures from one month to the next could generate a large loss for the ETF, and lower gains for the investor, as new positions are purchased at a higher price [Note: for a good overview on the issues regarding the USO, see the following seekingalpha article].

As with all ETFs, make sure you look beyond the name, and have some idea how the price is set. The various 2X and 3X inverse ETFs may not be giving you the type of long-term hedge or position you are expecting, and the commodity ETFs may not be following the spot price as anticipated. Finally, always be sure that any index the ETF is following actually has the type of diversification and representation you are looking for. Some industry ETFs may be heavily weighted in just a few companies, or may be focused more on a specific sub-industry.