By Jim Fink on December 8, 2010

Leverage is extremely dangerous.

The performance history of leveraged ETFs has been miserable. One of the main reasons is that these funds achieve leverage by trading derivatives such as futures to hedge their positions and rebalance frequently. These derivative trades incur substantial transaction costs that significantly erode these funds returns. Ben Shepherd, editor of Global ETF Profits . is not a fan of leveraged funds, particularly those that rebalance on a daily basis. He recently wrote about a ProShares leveraged short fund that lost a lot of money even though the underlying index moved in the downward direction investors in the fund were hoping for:

According to a class action lawsuit filed in a New York federal court, during the period from Jan. 2, 2008, to Dec. 17, 2008, when the Dow Real Estate index declined 39 percent, ProShares UltraShort Real Estate Fund lost 48 percent. According to the scheme, it should have appreciated about 78 percent .

Leveraged ETNs: Monthly Rebalancings are Better Than Daily

The ETF industry responded to these complaints by offering funds that rebalance on a monthly, rather than a daily, basis. For example, I wrote last July in Leveraged ETN of Master Limited Partnerships: Taxes Galore and Risky that UBS had issued a leveraged MLP ETN that rebalanced on a monthly basis. Similarly, fund company Direxion has a line-up of leveraged index mutual funds that rebalance monthly. Twelve rebalances per year for the monthlies incur much less in costs than 250 rebalances per year for the dailies.

Somewhat similarly, but in a non-leveraged context, United States Commodity Funds has come out with 12-month versions of its popular crude oil and natural gas ETFs that roll only a fraction of their futures contracts forward per month instead of rolling their entire position each month. For natural gas, UNL is the 12-month version of the original UNG. For crude oil, USL is the 12-month version of the original USO.

While leveraged index funds and 12-month commodity funds that rebalance/roll less frequently have proven to track their benchmark indices more closely, the fact remains that they still rebalance periodically and incur costs that cause tracking error.

There must be a better way.

Extended Leveraged ETNs Have No Rebalancings

On November 30 th. Barclays plc (NYSE: BCS) announced the introduction of Extended ETNs. The word extended means no rebalancing at all. This is great news. Once you buy one of these ten extended ETNs there are leveraged long and leveraged short versions for five separate stock indices you can be confident that you will receive the leveraged return expected minus management and financing fees . These fees can be significant and eat into returns, but all leveraged funds have them. Consequently, theyre an indictment of leveraged funds generally, not of these extended ETNs specifically.

Leveraged ETN Fees Remain a Problem

As an example, the leveraged long extended ETN on the S&P 500 (NYSE: SFLA) has an annual management fee of 0.35% and an annual financing fee of three-month U.S. dollar LIBOR (London Interbank Offered Rate) currently 0.30% plus 0.60%. Add all these fees together, and an investor who holds the ETN for a year will see her return reduced by 1.25%. If LIBOR rises, the haircut will be even greater.

The financing fee represents the amount of interest needed to purchase on margin a three-time levered position in index securities. Right now, LIBOR is low but that could change quickly if inflation rears its ugly head. With no end in sight to the U.S. governments trillion-plus budget deficits. a debasement of the U.S. dollar (i.e. inflation) is virtually a certainty. As I wrote in Best Asset Classes for Stagflation . hedge fund legend Julian Robertson is making a big bet on inflation. At some point, LIBOR is going to rise significantly which will have a severe detrimental effect on this ETNs net returns.

Leverage is Not a Constant 2.0 or 3.0

Theres another wrinkle in these new extended ETNs: although the leveraged long extended ETN on the S&P 500 (SFLA) was issued on November 30 th at a leverage level of 3.0, the leverage level changes on a daily basis. You can find the current leverage level on the iPath overview page for each ETN under the category called participation. For SFLA, current leverage is 2.83, less than the original 3.0.

Leverage went down because the S&P 500 index has increased since November 30 th. For why this matters, take a look at the chart at the bottom of the iPath participation page. Simply put, leverage goes down if an investor buys in after the underlying index has risen and leverage increases if an investor buys in after the underlying index has declined. The good news is that whatever the leverage/participation level is when you buy in, it remains constant for the entirety of your holding period, no matter how long that holding period is.

So, if you buy in at a 2.83 leverage/participation level and the S&P 500 goes up by 10% in a year, you can expect to earn 28.3% (2.83*10%) minus fees. No more nasty surprises caused by rebalancing. Id rather buy a leveraged fund with a fractional leverage level of 2.49 or 3.17 but a relatively certain return than a leveraged fund with an even-steven leverage level of 2.0 or 3.0 but a wildly uncertain return. How about you?

Leverage Remains Risky Regardless of Rebalancing Costs

Lastly, leverage works both ways. Its great when it goes in your favor, but if it goes against you, the losses can be horrifying. Adding substantial fees on top of index losses will make the losses even bigger. Large losses can be devastating to your wealth. As I wrote in The Great Investment Truth . this negative result occurs because of the asymmetrical wealth effects of gains and losses, with losses having a greater effect. Consequently, although the end of rebalancing will save you some fees, it wont protect you from the inherently risky nature of negative leverage.

BARX and iPath are Similar Leveraged ETNs Only One Brand Will Survive

As an aside, Barclays came out with some similar extended ETNs last year under the BARX brand. but they have different fees. For example, Barclays Long B Leveraged S&P 500 ETN (NYSE: BXUB) was issued at the same 3.0 leverage level as SFLA, but its leverage level has had more time to deviate from the initial 3.0 and its financing fee is 0.75% plus three-month U.S. Treasury bills rather than SFLAs 0.60% plus three-month LIBOR. On its face, BXUB appears to have higher fees, but three-month treasuries only yield 0.15% compared to LIBORs 0.30%, so the fees appear to be nearly equivalent. The bigger difference is leverage. BXUBs leverage level is currently 2.49 compared to SFLAs 2.83.

The difference has caused SFLA to significantly outperform BXUB since November 30 th. with SFLA returning 11.8% compared to BXUBs 9.4%. Almost 2 percent greater returns in only six trading days! Of course, relative performance would have been very different if the S&P 500 had declined over those six days rather than risen.

Both the BARX and iPath brands cant survive they are too similar. If I were a betting man, I would place my wager on the new iPath winning out. It has a better and more understandable website and its funds have names that are clearer and more informative than BARXs vague letterring system. Even though iPaths SFLA has only been trading a few weeks, it already has average daily trading volume more than triple that of BARXs BXUB. Only time will tell, but it behooves investors to try to figure out which ETFs/ETNs are likely to fail and avoid them. As Ben Shepherd of Global ETF Profits cautions his subscribers :

Investors need to pay attention to the asset levels and trading activity in the ETFs they hold. In an environment where its relatively cheap and easy for asset managers to launch new issues, theyre prone to throwing some oddball ideas against the wall and l iquidating whatever doesnt stick .

If youre holding shares in one of the funds that fail to catch on, youll find yourself scrambling to find another fund that fills that niche in your portfolio. You might also get stuck with an unexpected tax bill on any gains you might have, since liquidations count as taxable events.

In conclusion, I think Barclays extended ETNs with no rebalancing are a huge advance over the leveraged funds that existed before. Just keep in mind that leverage remains a dangerous thing even without the added costs of rebalancing.

Invest in Safe ETFs with the Help of Global ETF Profits

Global ETF Profits co-editors Ben Shepherd and Yiannis Mostrous have 20 ETFs in a multitude of different industries that are in buy range right now. None of them are burdened by leverage and yet several have generated double-digit returns. It just goes to show that ETF investors can profit handsomely without the need to resort to high-risk leverage.

For a list of safe ETFs best positioned to appreciate in value right now, consider giving Global ETF Profits a try.