Leveraged ETFs: You either love them, or you hate them, but regardless of which side of the spectrum you're on, there's one thing we can all agree on: they're dangerous. I want to first disclose the caveat that these investment instruments are speculative trading vehicles with a very high level of risk. I do not recommend using leveraged ETFs if you are a novice investor. There's no denying, leveraged ETFs are very perilous, but as the saying goes, "The higher the risk, the higher the reward."
Now, with that said, I could write an entirely different article on the negative compounding effect of daily leveraging, but for the sake of brevity, I'm not going to do that, and instead, I am going to recommend something that nearly every single ETF trader will cringe at: holding a 3x leveraged ETF for more than a few days. Before you start to get red in the face -- read, I will explain why I think this could ultimately be beneficial and profitable in the coming months.
With the Dow reaching its all-time high last week and the bears showing no sign of coming out of hibernation (not yet at least), investors have pushed ahead and continue to press the buy button. It's been a wonderful ride if you entered the market in 2009, when the market started its promulgated upward trend. Interest rates are low, consumer spending has increased and life has been good for the last four years, but will it last forever?
Direxion Daily Financial Bear 3X Shares (NYSEARCA:FAZ) can be used for speculation or daily hedging purposes by sophisticated investors. This ETF is designed to produce triple the daily inverse return of the Russell 1000 Financial Services Index. The pain for bears and many bearish funds has led to Direxion, a leader in providing popular alternative investment solutions, to decline ever since the market started to recover in 2009 - FAZ went from a high of almost $4,000/share in February of 2009 to a dismal current price of around $10.60/share.
Another Bear-leveraged ETF offered by Direxion is the Daily Small Cap Bear 3x Shares (NYSEARCA:TZA) which derives inversely (or opposite) of the performance of the Russell 2000 Index by 300%. For example, if the Russell 2000 goes down 10%, this ETF is designed to increase by 30%. TZA is down 49% in a year, currently trading at $9.50, and to bring the product to an investment price that Direxion believes is more attractive, Direxion announced that it would be making a reverse split. The reverse split of shares only really negatively impacts investors who own common shares at a total that is not a multiple of four, as they will be forced to sell fractional shares at a loss, or a potential gain, that could results in a taxable event. Similarly, ProShares UltraPro Short Russell2000 (NYSEARCA:SRTY) also invests in derivatives that ProShare Advisors believe in combination, should have similar daily return characteristics as three times the inverse (-3x) of the daily return of the Russell 2000. The index is a measure of small-cap U.S. stock market performance, which increases overall volatility- as if it weren't high enough!
The chart below is representative of the price performance for SRTY over the last few years. As you can see, since the economic recovery started to begin in March of 2009, this bear-leveraged ETF has been declining at an alarming rate. However, directly below the price performance graph, you'll see the EMA for the volume of the stock has substantially increased over the last few years. As I went back and looked at the aforementioned ETFs, I noticed a very similar trend- all are experiencing higher levels of volume, specifically in the last few months. This could be for one of two reasons. One, people are selling because the market is showing tremendous increase, or two, people are buying with expectations of the bull cycle coming to an end soon.
You may be asking question, "Why is he showing us bear-leveraged ETFs when the market is clearly on a record-breaking bullish trend?" My answer is simple - no bull market lasts forever. The adage "Sell in May and Go Away," in drawing upon us, and with many analysts predicting a sharp downward spiral in the coming years due to the uncertainly in the governmental debt and the Fed's quantitative easing program, this market is certainly in no position for "Dow 20,000 and beyond," as some analysts claim. As I have reiterated several times throughout the article, Leveraged ETFs are extremely volatile and should only be used by assessing your individual risk tolerance and deciding if can monetarily accept their natural volatility.
The recent word on Wall Street is that our market is currently over-inflated, with some estimates that a bearish correction of 3-5% could be on the way- and that's on the low end. While the argument can be made that stocks are relatively cheap right now if you compare the P/E ratio of 2007 to our current market, my counter is that the recent record profits recorded by companies are also inflated due to the increased liquidity of the market. Interest rates are low, leading consumers to borrow more money, spend more money, and in turn has led to increased company profits. It's not rocket science that a positive correlation exists between companies reporting record amounts of cash piles and the increase in the US monetary base - the US monetary base has nearly three-folded in the last six years!
We could debate my foregoing statements forever, but my main message is simple. This bull market is not going to last forever, and with the historically bearish month of May drawing near-with the exception of last year- bear-leveraged ETFs are something to consider in the next few months. I believe the increase in volume of these funds are a direct indication of where consumer sentiment in heading. Do leveraged ETFs have negative compounding effects? Most of the time. Are they extremely dangerous? Absolutely, and they should only be bought with those admonitions in mind, but as the wise Albert Einstein once said, "Great spirits have often encountered violent opposition from weak minds."