Reverse Splits: Why Leveraged ETFs All Go to Zero

by ETF Base on June 17, 2010

I couldn’t help but notice the press release today on the reverse splits announced for 4 more leveraged ETFs:

  • Direxion Daily Energy Bear 3x Shares (ERY)
  • Direxion Daily Real Estate Bear 3x Shares (DRV)
  • Direxion Daily Small Cap Bear 3x Shares (TZA)
  • Direxion Daily Technology Bear 3x Shares (TYP)

Some Details on the Reverse Splits:

  • These splits will occur for all shareholders of record after the market closes on July 7.
  • They will undergo 5:1 reverse splits, thus increasing the share price by 5X and decreasing the number of shares held by 5.
  • No transaction fees are assessed when such a transaction occurs.
  • If there are fractional shares, you’ll have the cash proceeds delivered via cash to your trading account.

This has become somewhat of a routine occurrence.  I got an email from one reader a while back rejoicing over how much his ETF had risen in value since he last checked recently only to be informed that this was due to a reverse split and he now owned fewer shares.  Whoops!  But this is all too common; sometimes, charting results on financial websites can’t even keep up with all these reverse splits on leveraged ETFs.

For the uninitiated, leveraged ETFs offer 2X or even 3X the DAILY return of a particular sector or index.  I emphasize “daily” because over time, it is a mathematical certainty that unless there is a pure sustained trend in one direction for an infinite period of time (what comes up must come down), the value of your holdings will decrease over time due to leveraged ETF daily rebalancing.

Admittedly, in some circumstances, I’ve employed leveraged ETFs to jump on a trend as a TRADE, not an investment, like when the Euro was imploding, utilizing EUO to short the Euro on a 2x basis (position closed for a small gain).  However, I never, ever recommend blindly holding any leverged ETF given the eventual demise in share price.

All you have to do is look at the evidence:

  • Past history – just view a long/short combo in Google Finance over a multi-month period and in many cases, they’ve actually BOTH lost money!
  • Continued Reverse Split Announcements
  • Warnings on the prospectus themselves

Despite the warnings and even new margin requirements (which really only made it more costly for traders, but likely won’t deter retail investors from using them), new investors that don’t fully understand this phenomena continue to pile into these instruments.  There is so much demand chasing supercharged returns that 16 New Leveraged ETFs just launched earlier this year.

Disclosure: Currently engaged in various short pairs trades with leveraged ETFs but no net long position in any leveraged ETF.  My current portfolio can be viewed for reference which is updated monthly.

{ 5 comments… read them below or add one }

Scott September 16, 2010 at 5:17 am

Thanks for the informative article. I am currently working on a speculative trading strategy that only trades 3x Leveraged ETFs for smaller account appreciation.
One good point is that because the fund owners want to keep making money, they will continue to do reverse splits.

thanks,
Global 34

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jake gold December 30, 2010 at 7:26 pm

I bought and hold Ultra Basic Materials in April 2009. My return to date is 287%. You can achieve long term returns in a leveraged ETF in a directional market.

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ETF Base December 30, 2010 at 7:59 pm

Congrats; the pivot bottom in equities and commodities was March. Try taking a look at any timeframe prior. It’s abysmal. Assuming you’ll enter at pivot bottom with no corrections for any asset class is quite dangerous-the odds are infintessimally small.

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mh March 1, 2011 at 5:25 pm

Hi fellas, I had a quick question.

I am fairly inexperienced in the financial world. I’ve read about Buy and Hold and chose to tie up some of my retirement in some Vanguard ETFs. This concept of Reverse Splits is completely foreign to me. I understand the concept as you explained it, but I don’t see how the value is affected if share prices increase… is that only in the case of a Leveraged ETFs?

I bought a few Vanguard ETFs because their expense ratio is half of what the equivalent mutual fund goes for.

I would just like to know if my investments are subject to the Reverse Splits that you mentioned? Does the fact I am Not leveraging give me any breaks?

Obviously the expense ratio is irrelevant if I would lose more money on an ETF using the same stocks at the Mutual fund…

Any help would be appreciated.

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ETF Base March 1, 2011 at 7:52 pm

A reverse split has no net impact on total holdings. It just raises the share price and decreases the shares you’re holding in an inverse fashion, so $1000 before split is still worth $1000 after. The reason I pointed it out for leveraged ETFs is that it further illustrates how they’re doomed to fail over time since they constantly have to undergo reverse splits just to maintain a reasonable share price – or else they’d be trading at sub-$1.

Vanguard is great for their low fees and ethical business practices.

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