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Summary A Seeking Alpha author highlights an unfortunate experience he had with a leveraged ETN. This article takes a closer look at the math – was the leveraged ETN to blame? The real dangers of using leverage ETFs and ETNs are presented. In a recent article entitled ” How I Got Burned By Leveraged ETNs “, Seeking Alpha author David Butler relates an unfortunate experience that he had with a 3x leveraged ETN, the VelocityShares 3x Long Crude Oil ETN (NYSEARCA: UWTI ). He writes about his investment: I bought in again at $3.64 believing the sky was the limit. Was it a dumb buy? Absolutely not. The mistake was not paying attention. Due to the big unrecoverable hits you can take on leveraged ETNs, you have to watch them closely and cut your losses quick if you start to lose. I was over confident. My past success had me thinking I couldn’t lose with this wonder security. Two weeks later, oil was in the beginning of its next downtrend…and I was kicking myself for losing a big portion of my previous gains. Did I take my medicine, cut my losses and sell? You all know the answer to that one. I waited. I thought “maybe oil will jump back up and I’ll get it all back”. Did it happen? You know the answer to that one too. UWTI’s chart says it all…. The author also presented an oft-quoted scenario, where the price of a security alternately increases and decreases by 10%, causing the corresponding 2X ETN to rapidly decay (original source ). In closing, David writes: Today, UWTI is trading at just around $1. Decay, combined with oil’s downward spiral killed me. Leveraged ETFs/ETNs Over the years, a number of Seeking Alpha authors have espoused on the pros and cons of leveraged ETFs or ETNs. At one extreme, Canary Cash gives reasons ” Why You Must Never Ever (Ever) Invest In A Leveraged ETN For Much Longer Than A Day “, one of which is the decay that occurs when the index increases and decreases successively. On the other hand, Dane Van Domelen has argued in an article entitled ” What The Numbers Say About Long-Term Investments In Leveraged ETFs ” that daily swings of plus- or minus-10% are exceptionally rare, and in most cases, the decay issue is much less serious than initially claimed. My personal portfolio also includes a number of income-generating, 2x leveraged funds, including the UBS ETRACS ETNs which I have written about extensively (see this article for a summary of the ETRACS line-up of 2x ETNs). By resetting monthly, these ETNs appear to partially mitigate the decay issue associated with daily-resetting funds. I have also studied the practical issues associated with harvesting this decay by shorting leveraged ETF/ETN pairs. Therefore, I was interested in further studying the reasons why David Butler’s investment in UWTI performed so poorly. Was it due to the inherent decay of leveraged ETFs/ETNs, or was it something else? At this juncture, I wish to emphasize that while much of this analysis focuses on David’s investment decision in UWTI and its associated consequences, this event could have happened to anyone, including myself. Furthermore, I do not intend to (nor am I qualified to) make a judgement on whether David’s investment at the time was “good” or “bad” – hindsight is always 20/20! The following is therefore intended to be a general analysis of the issues associated with an individual investing in any leveraged ETF/ETN. Comparing the 1x and 3x funds In his article, David writes that he bought UWTI at $3.64, but sold at around $1.00. As David did not provide the exact dates of his buying and selling, let’s assume that he bought on the last day that UWTI closed above $3.64, i.e. Jun 10th, and sold on the first day that UWTI closed below $1.00, i.e. Aug 19th. The following chart shows the price change for UWTI between those dates, together with the corresponding 1x fund, the iPath S&P GSCI Crude Oil Total Return ETN (NYSEARCA: OIL ). As expected, the 3x fund has done much worse than the 1x fund, but not three times as poorly – that would be impossible as it would take the price of the UWTI into negative territory. UWTI and OIL returned -74.6% and -39.0%, respectively, during this period. It is known that leveraged ETFs/ETNs suffer from beta decay or slippage when the underlying asset is volatile with no net change over a period of time. However, note that both UWTI and OIL declined nearly monotonically during the test period, with no notable rallies. Therefore, I would have to conclude that the beta decay or slippage of ETFs played only a small, if any, part in UWTI’s decline. The same exposure without leverage Let’s consider a hypothetical investor “Joe” who invests $10,000 into UWTI over the time period indicated above. Let’s also consider Joe’s twin brother, “Jack”, who has read about the dangers of using leveraged ETFs/ETNs and the decay associated with such funds. However, he still wants to have the same exposure to oil as Joe, so he instead decides to invest $30,000 into the corresponding 1x fund OIL. How have Joe and Jack fared over the time period indicated above? Since UWTI declined by -74.6%, Joe’s $10,000 investment has dwindled into $2,540, which represents a loss of $7,460. On the other hand, Jack’s $30,000 investment in oil declined by “only” -39.0% to $18,300, but because of his larger initial base, his nominal loss comes out to be $11,700, which is more than 50% that of Joe’s. In other words, investing $10,000 into a 3x fund rather than $30,000 into a 1x fund actually benefited Joe during oil’s decline, even though both brothers had the same apparent exposure to oil. The reason for this is quite simple. At the risk of stating the obvious, the maximum loss of a $10,000 investment is $10,000, while the maximum loss of a $30,000 investment is $30,000. Once OIL declined by more than 33% (turning Jack’s $30,000 into $20,000), there was no way that Joe could lose more money than Jack. In fact, if Jack had purchased OIL on 50% margin, a -39.0% fall in the fund will bring his percentage of equity to 18.0%, below the minimum maintenance requirement of most brokers, thus possibly triggering a margin call and leading to forced selling. The real danger of leveraged ETFs and ETNs The results of this exercise suggest that the real danger of leveraged ETFs and ETNs is not their inherent leverage, nor their associated decay. In my opinion, the first real danger of leveraged ETFs/ETNs is that investors “forget” that their investment is leveraged and neglect to position-size accordingly. This observation leads to the following advice: Only invest $10,000 in a 3x fund if you are entirely comfortable with investing $30,000 in the corresponding 1x fund . The second real danger of leveraged ETFs/ETNs is that any changes in price become amplified, leading to either of two pitfalls, the first of which is overconfidence. David Butler writes: I first bought the VelocityShares 3x Long Crude Oil ETN [UWTI] back in March for $2.24. Less than a month later I sold at $2.53. As the Exchange traded notes kept climbing I bought back in again at $2.82 and sold at $3.20. Suddenly, I was hooked on the volatility of oil ETFs and ETNs. David pocketed a cool 13% in less than a month on his first UWTI investment, while the underlying index might only have appreciated by around 4%. His second investment also returned 13%, although the time frame was not stated. A double-digit monthly return would undoubtedly be the envy of all of Wall Street, and it is understandable as to why an investor would become overconfident in such a situation. The second pitfall associated with amplified price changes is that when prices go south, the large proportional decrease in the leveraged fund might trigger panic in an investor, leading to selling at inopportune times. Notwithstanding the fact that such a panic sale might, in hindsight, have been the correct decision, it is a generally-accepted maxim that emotional behavior is best left out of stock-market decisions. Summary While a 74.6% loss in any investment is no fun, David Butler could possibly be comforted by the fact that had he invested three times of his UWTI investment amount into the corresponding 1x fund OIL, he would have lost over 50% as much money, despite having the same apparent exposure to oil. It is my opinion that the true dangers of leveraged ETFs/ETNs are not due to any structural issues associated with leverage or decay. Rather, I believe that the two main dangers of using leveraged products are both psychological . The first is the issue of position-sizing, and I believe that my advice from above bears repeating: Only invest $10,000 in a 3x fund if you are entirely comfortable with investing $30,000 in the corresponding 1x fund . only invest $10,000 in a 2x fund if you are entirely comfortable with investing $20,000 in the corresponding 1x fund . The second danger is that the amplified price movements of leveraged ETFs/ETNs can trigger either overconfidence (when prices go up) or panic (when prices go down) in the everyday investor. Finally, I should make the very obvious point that it is the choice of the underlying security that primarily determines a fund’s performance, and not whether it is 1x or 3x leveraged. Had Joe instead invested $10,000 into the VelocityShares 3x Inverse Crude ETN (NYSEARCA: DWTI ), the 3x leveraged short version of OIL, his investment would have ballooned to $31,670. DWTI data by YCharts I hope that this analysis was helpful for investors considering investing in leveraged ETFs or ETNs. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.