Before the electronic ink could dry on last week’s column, Is the Gold/Silver Ratio at a Tipping Point?, silver crashed. So did ETFs that track this niche in the precious metals market. I hope you avoided all the fireworks.

The break in silver gives us a good opportunity to look at how ETFs behave in a fast-moving market. The popularity of leveraged and inverse ETFs means more than a few investors didn’t get what they had expected.

The Perils of Leverage

Leverage is nothing new. Stock traders have been trading “on margin” (with borrowed money) for centuries. The results can be good or bad. Leverage is simply a tool; what matters is how you use it.

Back in 1993, leverage suddenly got a lot more accessible with the first leveraged mutual fund, Rydex Nova (RYNVX). This fund offered a new twist: The daily change in the S&P 500, times 150 percent. Or as traders say: “1.5x.” Now many mutual funds and ETFs offer similar capability — in some cases up to 3x daily leverage.

 Leveraged funds have been around for years, but many investors still don’t understand how they work.

The key word to remember is “daily.” Leveraged mutual funds and ETFs typically re-set their leverage factor every market day. There’s a good reason for this. The daily reset feature keeps investors from suffering a total loss or even more — something that can and does happen to people who trade on margin.

Leveraged ETF managers generally do a good job in tracking their benchmarks closely. Unfortunately, many investors don’t quite grasp what this means. They buy leveraged ETFs without knowing how a daily leverage reset can affect their returns over longer periods. Instead, they focus on the multiplier and say: “If my benchmark index goes up 20 percent in a week, then my 2x leveraged ETF will make 40 percent.”

That’s not how it works …

In fact, if your selected market has a 20 percent weekly gain, a 2x leveraged ETF could rise much more than 40 percent — or much less. It all depends on the sequence of daily results.

To help you see how this works, I’m going to call on some old friends from elementary school: Dick, Jane and Spot. Each will represent a silver-related ETF.Fun with Dick, Jane and Spot

• Loyal dog Spot is the iShares Silver ETF (SLV), which owns actual silver bars. Hence the price moves very closely with the “spot” price of silver bullion.
• Second-grader Dick will play the role of ProShares Ultra Silver (AGQ), a leveraged ETF that tries to deliver 2x the daily change in silver bullion.
• Young Jane, who is very intelligent but likes being contrary, behaves just the opposite of Dick. Her part in our lesson is to be ProShares UltraShort Silver (ZSL). This is an inverse leveraged silver ETF — AGQ in reverse.

So here is what should happen: If Spot (silver bullion) moves up 1 percent on a given day, Dick (AGQ) should go up 2 percent that day. Meanwhile Jane (ZSL) should move 2 percent in the other direction — down, in this case.

Likewise, if Spot goes down 5 percent in a day, Dick should be off 10 percent and Jane should go up 10 percent that day.

Now let’s look at what actually happened in silver ETFs in a particularly volatile four-day period just last week.

On Monday May 2, Spot dropped by 8.6 percent. Dick’s job was to double this move so he should have been down 17.2 percent. In fact he did a bit worse, losing 17.4 percent that day. Jane should have been up 17.2 percent, but actually rose only 16.6 percent. However, given the magnitude of the moves, Dick and Jane did their jobs very well.

On Tuesday May 3, Spot fell 5.3 percent. Dick was right on target, declining 10.6 percent. Jane again fell short of her mark by gaining “only” 10.1 percent.

Wednesday May 4 brought a similar pattern: Spot down 5.7 percent, Dick down 11.6 percent, and Jane up 11.1 percent.

By Thursday, May 5, Spot decided to go for a new record and ran 11.9 percent downhill. Dick dutifully went 23.4 percent in the same direction. Jane? She climbed 25.1 percent that day.

Now let’s look at the bottom line in this four-day race. You can’t just add the percentages together because there is a compounding effect.Who Is the Winner?

The right math tells us that Spot fell by 28.1 percent in this period. Dick should therefore have dropped 56.2 percent, right? Wrong! Dick’s job is to deliver 2x of Spot’s daily change, and then do it again the next day.

In reality, Dick fell “only” 50 percent instead of 56.2 percent. Meanwhile Jane, who actually fell short of her goal in three of the four days, gained a total of 78.4 percent instead of the 56.2 percent that casual investors may have expected.

What’s my point?

When leveraged ETFs and inverse leveraged ETFs reset their leverage factor, the results can be counterintuitive and surprising. ZSL was not a 2x ETF for this four-day period; it was closer to 3x. Yes, it worked to the investor’s benefit but could easily have gone the other way.

This variance isn’t necessarily a reason to avoid leveraged ETFs. It just means you need to understand how they work and what to expect. These instruments are really intended for short-term trading. They don’t work so well over longer periods, unless the daily moves continually work in your favor.

If you want to learn more about leveraged ETFs and inverse ETFs, see my past Money and Marketscolumns. You may be surprised. Better to read now than to learn about it the hard way later.

Best wishes,

Ron

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