How Reverse Splits Can Mask Big Losses

Exchange-traded funds have given millions of investors an easy and inexpensive way to invest for the long run. But if you play in the leveraged-ETF space, which has become extremely popular among short-term traders, holding on to fund shares over the long haul has been hazardous to your financial health.

Why you have to watch leveraged-ETF share prices closely
Last month, leveraged ETF specialist Direxion announced that 16 of its funds would do share splits. Effective today, half of those funds have completed ordinary share splits, where one share of stock has turned into two or three new shares, each worth a half of a third of their former price. The other eight funds did reverse splits, where multiple shares of old stock will be converted to a single new share, with its price adjusted upward to keep the overall value constant.

Regardless of their direction, the various splits won't affect how much your leveraged ETF holdings are worth. But what they do accomplish is keeping the prevailing share price within a fairly well-established range that's comfortable for the traders who use them. Keeping prices not so high as to make them illiquid yet not so low as to make them imprecise is an art, but the split activity seeks to accomplish that balancing act.

How splits mask long-term returns
The problem, though, is that to the casual observer, splits and reverse splits make it seem as though share prices of leveraged ETFs stay in a relatively consistent range. But over the long haul, that hasn't been the case. The declines in losing leveraged ETF bets have outpaced the gains in others, and in some cases, both bullish and bearish ETFs covering the same sector have produced losses for investors.

You can get one hint of the overall negative bias just by looking at the split ratios. The eight funds doing regular splits are using 2-for-1 or 3-for-1 ratios. But among the reverse-splitting funds, those ratios range from 1-for-3 all the way up to 1-for-6.

The losses that many of those funds have suffered make such extreme reverse splits necessary. In just the past year, Direxion Daily Gold Miners Bull 3x has lost more than 65% of its value, while Direxion Energy Bear 3x was down 45%, with the two funds splitting 1-for-5 and 1-for-6, respectively.

More broadly, funds that bet against the stock market's run have been hit hard. Direxion Daily Small-Cap Bear 3x is down by almost half over the past year, after a similar drop from April 2011 to April 2012 and even more dramatic declines during the first two years of the market's recovery.

Proponents of the funds note that in some cases, ETF pairs have reacted in much the way you would expect. With financial stocks having moved almost straight up over the past year, the popular Direxion Daily Financial Bull 3x rose more than 50%, even as the bearish counterpart Direxion Daily Financial Bear 3x lost almost half its value.

But when you go back even further, you'll discover an alarming result: Both ETFs have lost ground since their inception. Even from the depths of the financial crisis in November 2008 when it traded for the first time, the bullish ETF has lost 6% of its value when adjusted for splits, according to historical data provided by Yahoo! Finance. Meanwhile, the bearish ETF has lost 99.8% of its value.

Buyer beware
To their credit, leveraged ETF managers have figured out that they need to be absolutely clear about the ramifications of their strategies over longer periods of time. Direxion is very clear that it only seeks daily returns, not long-term returns, building the daily aspect into each fund's name. It would be harder for Direxion to be clearer about these funds not being suitable for most long-term investors.

But what these funds' share-splits remind you is that you can't just look at raw share prices to get a sense of returns. For reverse-split shares, it's easy for investors to miss just how extensive losses have been for many leveraged ETFs over the years.

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