Morningstar Advisor - April/May 2009 - 41

Double Your Pleasure: How funds pegged to the price of oil would perform over 12 months. The more layers of leverage, the larger the losses. Month Crude Oil Price ($) Traditional Single Long ETN ($) Single Short ETN ($) Double Long ETN ($) Double Short ETN ($) Triple Long ETN ($) Triple Short ETN ($) You’re up 52%, and he’s lost money. Compounding returns strike again. Here’s one more example. We constructed an imaginary fund that delivers twice the monthly returns on a barrel of crude oil, charges an annual fee of 0.75%, and pays interest at the T-Bill rate of 0.3%. This profile is very similar to PowerShares DB Crude Oil Double Long ETN DXO. In our example, oil is priced at $35 today, and the price goes up $5 every month for the next six months. After six months, you’d be delighted to see that your initial $100 investment had grown to around $325, which is even greater than twice the promised return. The reason the fund would have gained 225% up to this point is that there was no single downtick: It was a perfectly straight upward trend—an event that very rarely happens. Now let’s assume that over the next six months, oil goes down by $5 per barrel per month. It ends the year exactly where it started, at $35. Because of the disappointing mathematics of the volatility drag, you would lose around 13% of your original investment, thanks to the fund’s leverage and compounding. (Oddly enough, a single-short ETN—betting against the index but without leverage—has the same return profile as the double-long ETN. Furthermore, the returns grow more negative with each successive layer of leverage employed.) Wake-Up Call 0 1 2 3 4 5 6 7 8 9 10 11 12 Annual Return 35 40 45 50 55 60 65 60 55 50 45 40 35 100.00 114.25 128.49 142.72 156.94 171.15 185.35 171.02 156.71 142.40 128.11 113.83 99.56 –0.44% 100.00 85.68 74.94 66.58 59.90 54.43 49.88 53.70 58.15 63.42 69.73 77.46 87.11 –12.90% 100.00 128.53 160.62 196.26 235.44 278.16 324.41 274.38 228.55 186.91 149.46 116.19 87.10 –12.89% 100.00 71.39 53.52 41.61 33.27 27.21 22.66 26.14 30.49 36.02 43.21 52.80 65.98 –34.02% 100.00 142.82 196.33 261.70 340.11 432.74 545.77 415.78 311.68 226.56 158.51 105.62 65.97 –34.02% 100.00 57.11 35.67 23.77 16.63 12.09 9.06 11.15 13.93 17.73 23.04 30.71 42.21 –57.79% stand at only $2.54. Yes, that’s a 97.46% loss. Talk about tracking error. That’s why compounding of daily returns is the dead horse that apparently needs a little more beating. Leveraged and inverse ETFs are not meant to be held as long-term investments. Whenever you hold these ETFs longer than their indicated compounding period (typically one day for stock-based ETFs, sometimes monthly for commodities), you are almost mathematically guaranteed to get a return that is not double that of the index. In fact, the longer you hold one of these funds, the probability that you will get nothing close to double the returns increases. Not only will the magnitude of your returns bounce around, you might not even get returns that are in the same direction as the changes in the index. The Curious Case of Google Let’s pretend you jumped on the Google bandwagon on Jan. 3, 2005, at the market closing price of $202.71. You would have been euphoric until Nov. 6, 2007, when the stock closed at $741.95. Alas, you failed to pull the sell trigger that day, and you proceeded to hold on to Google until the end of 2008, when the stock closed at $307.65. At that point, you were content with your 52% return given that the S&P 500 had done nothing but nose dive. Let’s also say that you’re willing to share your market insights with your brother-in-law. You let him jump on your Google purchase. He’s crafty, however. He found an obscure ETF that promised double the daily returns of Google for a low yearly fee of 0.75%. Fast-forward to Google’s high in November 2007. While you were delighted that your sister would be well provided for, his nonstop bragging about his 677% return drove you nuts. Alas, once he heard that you were not ready to sell, neither was he. When the two of you met up again for New Year’s Day 2009, he’s fuming because he was not only given back his gains; he actually lost 2% of his initial investment. Just as we know that no real-world indexes only go straight up, we also know that many don’t see a positive day followed by an equal but opposite negative day. So here’s another example: Google GOOG was an instant sensation when it went public in August 2004. The ETF structure is well suited to house these leveraged instruments, and there are legitimate uses for these funds, mainly for institutions who manage large sums of money. For the rest of us, these vehicles are not suitable. Perhaps investors have been lulled into complacency. The traditional unleveraged products have worked so well at tracking indexes that investors maybe believe that reading the prospectus is a waste of time. We hope they wake up to the dangers before their portfolios are decimated. K Paul Justice, CFA, is an ETF strategist with Morningstar. MorningstarAdvisor.com 41
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Morningstar Advisor - April/May 2009

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