Exchange-Traded Funds is an investment fund that holds stocks, bonds, or commodities and typically tracks specific indices of such asset classes. Leveraged and inverse leveraged ETFs were first introduced to the market in June 2006 by ProFunds, which promiseds to return a multiple of the underlying index return by rebalancing their portfolios at the end of each day. The total market value of leveraged and inverse ETFs has grewrown from $1 billion in 2006 to more than $30 billion by 2010. FINRA has issued a Notice to Members and additional guidance whileand the SEC has issued an Investor Alert about leveraged and inverse ETFs.
In this paper we describe the problems associated with the daily rebalancing and the potential costs it may create for investors who hold these ETFs for longer than a few days. Further, we estimate the potential investment shortfall incurred by investing in these ETFs compared to investing in a simple margin account. We find that a substantial percentage of investors hold these ETFs for periods longer than one or two days, even longer than a quarter. Consequently, investors in leveraged and inverse leveraged ETFs can lose 3% of their investment in less than 3 weeks, an annualized cost of 50%.
