It seems like every month the Securities and Exchange Commission approves more and more new exchange-traded funds. In fact, at least 10 firms have a total of 291 ETFs waiting for SEC approval.
ProShares launched 22 funds on Feb. 1. Each of the funds tracks a Dow Jones index covering a narrowly focused industry group. Eleven of the new funds take the positive or long side, rising as the index rises. The other 11 take the short side, rising as the indices fall. The funds use leverage in an attempt to return twice the performance of the indices.
It is true that these new ETFs intentionally lack diversification by being industry-specific. But the 200% leverage does allow an investor to balance a portfolio with half as much cash equity.
For traders, the leverage amplifies small movements and the ability to bet an industry will fall, both without the use of a margin account.
It will be a year before TheStreet.com Ratings' risk-adjusted return model has enough performance and volatility data to generate a rating for these new ETFs. However, it is not too soon to see how the underlying indices did in the last year, which could give an indication about how the ETFs would have performed.
The table below lists the Dow Jones indices tracked by ProShares' new ETFs and the total return for each. The comparable performance level shows how each index would have stacked up against the one-year returns of funds we rate.
When doubling the returns, we can see what the hypothetical return might have been assuming no expenses and no tracking errors. The UltraShort funds were multiplied by -200% to show their double inverse relationship to the underlying indices.
The hypothetical performance level approximates how the funds might have ranked on a one-year total return basis against the funds we currently rate. Leverage can work in your favor if you pick the correct direction of the index. As of Feb. 6, the one-year total return of 16.9% on the Consumer Services index could have turned into an excellent return of 33.9%.
On the other hand, leverage can do significant damage to your portfolio if you make a mistake on which way the market is moving. With the exception of the fund levered to the semiconductor index, which fell for the year, all of the UltraShort funds would have been caught on the wrong side of a bull market for these sectors, knocking the stuffing out of your portfolio.
This analysis does not consider volatility, the risk portion of our ratings. Only the hypothetical performance is listed and compared with the average total returns of the top 30%, middle 40% and bottom 30% groups of the funds we rate. So the above table does not represent how these funds could have done on an overall risk-adjusted return investment rating.
The 200% leverage employed by these funds increases volatility, resulting in worse risk ratings when ranked against nonleveraged funds holding the same stocks. Caution is warranted.
Kevin Baker became the senior financial analyst for TSC Ratings upon the August 2006 acquisition of Weiss Ratings by TheStreet.com, covering mutual funds. He joined the Weiss Group in 1997 as a banking and brokerage analyst. In 1999, he created the Weiss Group's first ratings to gauge the level of risk in U.S. equities. Baker received a B.S. degree in management from Rensselaer Polytechnic Institute and an M.B.A. with a finance specialization from Nova Southeastern University.