Exchange traded funds (ETFs) have changed the face of investing for individuals as well as institutions.

These relatively new investment tools have made it easier to play sector rotations, go short the market or even leverage positions.

Yet at this point in the market cycle, this leverage becomes a double-edged sword for a particular set of ETFs: the Ultra set.

You see, investors like me who adopt a macro, top-down approach often want to use ETFs to take a position on an enticing sector.

[ad#Google Adsense 336×280-IA]Having made that decision, we’re then tempted by Ultra ETFs, which offer us the possibility of 2x or 3x our gains.

Resist the temptation.

In general, Ultra ETFs are a snare, not because of any dishonesty in their sponsors, but because of the way they work.

Ultra funds are a species of ETF that attempt to double or triple the return you get on a particular asset class – on the long or short side.

They do this by taking a futures position, long or short, that’s 2x or 3x the amount of funds they have under investment.

The problem is that each night, when they calculate the net asset value of the fund, they must also adjust the futures position so that it’s twice or three times the new value of the fund.

Too Good To Be True? Yes.

However, if the asset class bounces up and down in value, the ultra fund is continually buying high and selling low. Thus, over time it accumulates a “tracking error.”

Depending upon the volatility of the asset class, this tracking error can prevent it from achieving the advertised performance, and it can make the fund decrease in value even when it should have increased.

For example, since January 2012, the unleveraged iShares Barclays 20+ year Treasury bond ETF (NYSE:TLT), which tracks the long-term Treasury futures contract, has declined in price from roughly 116 to 110, roughly a 5% decline.

You’d expect the ProShares UltraShort 20+ year Treasury ETF (NYSE:TBT), which was trading at about 73 in January 2012 and is supposed to track the inverse TLT with 2x leverage, to have increased by about 10%, to about 80.

You’d be wrong; TBT is still trading around 73.

And the Treasury bond futures contract has high trading volume and normally doesn’t bounce around much. Yet even in this low volatility operation, over an 18-month period, the 10% profit you expected to make disappeared altogether.

In a higher-volatility operation, the results can be much worse.

I was invested in the ProShares UltraShort FTSE China 25 ETF (NYSE:FXP) in 2007-08 — this one attempts to get 2x the inverse performance of the iShares FTSE China 25 Index Fund (NYSE:FXI).

I was correct about the Chinese market – it halved in about 9 months – but so did my investment in FXP.

Since January 2012, FXI is down about 10%, so FXP should be up about 20%, right? Well, it’s actually down 20%.

DIY Ultra ETFs

That means you would have lost less money going long the plummeting Chinese market than if you had a leveraged short position. In other words, the only thing you’re hedged against with many of these Ultras is the possibility of making a profit.

Of course Ultra funds are not nearly such bad investments as a trading vehicle, with a time horizon of a few weeks.

But over such a short period, the cost of selling a stock short is not that great. So even as a trade, you’d do much better selling TLT or FXI short than you would buying the corresponding Ultra inverse fund. You could even make your own Ultra, using margin to sell 2x short instead of using the Ultra ETF.

ETFs can be a very useful tool to give you exposure to a particular sector. If you feel strongly, you can get inverse exposure by selling the ETF short – provided you don’t hold the position too long.

But Ultra funds are just a recipe for losing money.They make money for their sponsors, but they’re very unlikely to make money for us as investors.

— Martin Hutchinson

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Source: Money Morning