A graph of why you should not hold levered ETF's long term

DO you remember last week when I tweeted from the FMA conference about the luncheon speaker who pointed out the fact that levered ETF's that regularly relever are good at mirroring the market on a daily basis, but in the long term are bad bets since they are short an embedded option on Gamma which makes it very likely that the levered fund will be a money loser?


To show this, let's look at two levered funds that are designed to be bets on the Russell 1000 financial index.

I pulled the following two charts from for the Direxion Daily Financial Bull 3x (FAS) and Bear 3X shares FAZ). Both of these levered ETF's track the same index but the Bull fund is designed to move with the with the index (albeit 3Xs faster) while the Bear fund is designed to go in the opposite direction of the index at the same warp speed.

MSN describes the two funds as follows: The Bull Fund (FAS) as

"The investment seeks to replicate, net of expenses, 300% of the daily performance of the Russell 1000 Financial Services Index The fund will invest at least 80% of assets in securities that comprise the index. It will also utilize financial instruments that, in combination, provide leveraged and unleveraged exposure to the index. The fund is nondiversified."

and the same forthe Bear fund (FAZ) as :

"The investment seeks to replicate, net of expenses, 300% of the inverse daily performance of the Russell 1000 Financial Services Index The fund will invest at least 80% of assets in securities that comprise the index. It will also utilize financial instruments that, in combination, provide leveraged and unleveraged exposure to the index. The fund is nondiversified."

So "common sense" would suggest that if you bought each the overall returns (ignoring transaction costs) would be zero. BUT that is not the case, in fact, you would lose money long term not only in the combined position, but on both the Bear and the Bull funds individually as well!

Let's take it to the charts:

Here is the Five day chart of the underlying Russell 1000 Financial Services Index, the FAS and FAZ. Note how they move in almost exactly as we would expect. That is the bull fund moves, albeit more sharply, the index and the bear fund moves opposite direction.

Now the One year chart: of FAS and FAZ from Yahoo. Note how they both decline. That is why you do not want to be long levered funds in the long run.