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Thomas Bulkowski’s successful investment activities allowed him to retire at age 36. He is an internationally known author and trader with 30+ years of stock market experience and widely regarded as a leading expert on chart patterns. He may be reached at

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Bulkowski's What You Should Know About ETFs

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Busted
Patterns
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Patterns
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Market
Industrials (^DJI):
Transports (^DJT):
Utilities (^DJU):
Nasdaq (^IXIC):
S&P500 (^GSPC):
As of 09/18/2017
22,331 63.01 0.3%
9,515 -31.61 -0.3%
739 -7.54 -1.0%
6,455 6.17 0.1%
2,504 3.64 0.1%
YTD
13.0%
5.2%
12.0%
19.9%
11.8%
Tom's Targets    Overview: 09/14/2017
22,450 or 21,500 by 10/01/2017
9,750 or 9,200 by 10/01/2017
775 or 730 by 10/01/2017
6,650 or 6,200 by 10/01/2017
2,600 or 2,425 by 10/01/2017

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My book, Getting Started in Chart Patterns, Second EditionGetting Started in Chart Patterns, Second Edition book., discusses mutual funds and ETFs, so you may want to buy a copy of it.

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This article discusses a flaw in exchange traded funds that I call tracking error. For the leveraged funds, they are supposed to perform twice or three times as well as the associated index, but they don't.

 

A Look at Leveraged ETFs

When the leveraged 2x and 3x exchange traded funds (ETFs) came out, I thought I could just load up on them and double or triple the performance of the major indexes in the coming year by buying the correct ETF. Sadly, that is not the case.

You probably know that there are ETFs that follow the indexes both from the long side and the short side. For example, the DOG fund is supposed to mimic the Dow Industrials from the short side. Here is how yahoo!finance describes it: "The investment seeks daily investment results, before fees and expenses, which correspond to the inverse of the daily performance of the Dow Jones Industrial Average index."

A fund like DXD is designed to produce twice the inverse performance of the Dow, but there's a problem. I call it tracking error.

Here is what the ProShares website says about it.

Investors considering ProShares and other leveraged or short funds with daily objectives should not expect them to achieve their objectives over periods longer than one day (emphasis added), however. There are several reasons for this, but the most significant one is index volatility and its effect on fund compounding. In general, periods of high index volatility will cause the effect of compounding to be more pronounced, while lower index volatility will produce a more muted effect.

I decided to found out how well the funds do over the long term. Since the funds are new to the markets, their performance lifetime is short. The following shows some of the more popular ETFs.

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Dow Utilities

Year^DJUIDUSDP (-2x)
1/2/2002-25.33%-22.87%
1/2/2003-26.18%-20.73%
1/2/200421.23%22.33%
1/3/200524.11%21.22%
1/3/200625.06%17.73%
1/3/200710.67%17.42%
1/2/200814.86%13.96%
1/2/2009-27.94%-28.66%28.85%
Notes: DJ 15 Utilities, ^DJU
DJ US Utilities sector index fund, IDU
UltraShort 2x Utilities ProShares, SDP

Look at the above table. ^DJU is the Dow utility average. IDU is a sector fund and SDP is the new kid on the block, a fund that shorts the utility stocks at twice the volatility. The first row measures the close to close performance from January 2, 2001 to January 2, 2002. Over that period, the Dow dropped 25.33% but the index fund dropped 22.87%. That is not too bad.

Compare that to 2006 when the Dow gained 25% and SDP gained just 18%. In 2007, the ETF over-performed, beating the Dow by 17% to 11%.

Now look at the last row. The Dow dropped 27.94%, the index fund dropped 28.66% and the 2x short fund gained 28.85%. While a gain is what the 2x fund was designed to do (since it performs to the inverse of the Dow), it is far from the target 55.88% return (which is twice the Dow's performance) that one might expect.

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Dow Jones Industrials

Year^DJIDOG (-1x)DXD (-2x)DDM (+2x)
1/2/20084.56%0.11%-6.78%6.17%
1/2/2009-30.74%25.29%34.77%-58.73%
Notes: DJ 30 Industrials, ^DJI
DJIA short 1x ProShares, DOG
DJIA short 2x ProShares, DXD
DJIA long 2x ProShares, DDM

Above is the ETF comparisons for the Dow industrials. The DOG fund, shorts the Dow with 1x leverage. In other words, it should have lost 4.56% instead of gaining 0.11%.

The DXD, a twice leveraged short fund, doesn't come that close to twice the inverse Dow's performance (-6.78% vs 9.12%) over a year.

The DDM fund, also twice leveraged but from the long side, comes much closer to the -61.48% target by dropping 58.73%.

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Nasdaq 100

Year^NDXPSQ (-1x)QID (-2x)QLD (+2x)
1/2/200816.50%-10.02%-25.20%24.51%
1/2/2009-38.35%38.38%57.58%-69.52%
Notes: Nasdaq 100, ^NDX
Nasdaq 100 short 1x ProShares, PSQ
Nasdaq 100 short 2x ProShares, QID
Nasdaq 100 long 2x Ultra QQQ ProShares, QLD

The first thing that is tricky about these funds is that they do not track the Nasdaq Composite. Rather, they track the Nasdaq 100.

During 2007-2008, the QID (-25.2%) and QLD (24.51%) funds did not double the performance of the benchmark (33%) even though they are 2x funds.

In 2008 to 2009, the tracking was closer to the 2x target, 57.58% and -69.52% versus 76.70%.

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S&P 500

Year^GSPCSH (-1x)SDS (-2x)SSO (+2x)
1/2/20082.16%2.40%-2.45%-0.40%
1/2/2009-35.61%33.23%48.03%-65.23%
Notes: S and P 500, ^GSPC
S and P short 1x ProShares, SH
S and P short 2x ProShares, SDS
S and P long 2x Ultra SP 500 ProShares, SSO

The above table shows the ETFs against the S&P 500 index. Notice in 2007-2008, the 2x (long) SSO fund lost money even as the benchmark gained 2%.

What these tables show you is that holding an ETF for the long term can produce better or worse results than you expected. As Monty Python would say, nobody expects the unexpected.

-- Thomas Bulkowski

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Written by and copyright © 2005-2017 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Absence makes the heart go wander.