Absurd Inverse and Leveraged ETF Product Whining (Updated)

Editor's Note: This post was updated to reflect new developments in this sphere of the ETF industry. Its original publication date was June 28, 2009.

I’m a fan of these products, and am glad ProShares, Direxion, Rydex and PowerShares (via Deutsche Bank) have made them available. But like any other security or product, these issues need to be used properly.

When used correctly, they allow individual investors and advisors the opportunity to hedge and/or add more potential return to index-based securities.

An avalanche of complaints have been made recently by those taking the most egregious form of leveraged product use - buy and hold - to tar the entire levered ETF group negatively.

Sure, given the nature of how these products function, including within periods of high volatility and compounding issue complexity, they don’t achieve what some mistakenly believe is their job. But, this is not their proper use — period.

Leveraged issues should be used strategically and tactically by experienced investors over short periods of time, which may include day-trading and time periods of just a few weeks. To accomplish performance goals and achieve success, a disciplined and systematic approach is essential.

Commodity and currency markets have been difficult sectors for retail or financial advisors to participate in due to high entry costs for commodity pools and hedge funds, high ongoing fees and expenses, and even greater leverage than most investors are comfortable with. The introduction of ETF products in this area has given investors the opportunity to participate in markets previously unavailable to them. Trends in these market sectors can change quickly, and participating successfully in them therefore requires the careful application of trading methodologies. That’s what the most sophisticated investors in this sector do—they trade.

Have issuers done a great job of explaining this to the investing public? Probably not, but they’re working on it and so is the SEC, thanks to new education notices issued by FINRA (pdf).

Unleveraged inverse ETF products are a blessing to those investors wishing to avoid losing 40-50 percent of their portfolio’s asset value due to the occasional but devastating bear market, such as we’ve recently experienced. They don’t have the large tracking errors the whiners have ascribed to the entire product group.

Why shouldn’t retail investors and financial advisors be able to hedge or protect their own or their clients’ portfolios through the use of leveraged and inverse products?

Most complaints have come from those with inherent product conflicts. Jack Bogle hates ETFs. Nate Most (a wonderful gentleman now deceased) created the ETF while working for the American Stock Exchange. Excitedly, he took his baby to his friend Jack Bogle to see what he thought of his new product idea. Bogle’s response? “You mean investors can buy and sell these things intraday?” For a paternalistic buy-and-hold aficionado, the very idea was heretical! Since then, Bogle’s old shop, Vanguard, has jumped into the ETF fray with both feet, which must cause him great consternation.

Others simply don’t like the idea of short-selling - like our friend Jim Cramer, who routinely and theatrically describes leveraged products as “evil”. But when he was operating his hedge fund, Cramer shorted stocks routinely – and, to hear him tell the story, made money at it. Why shouldn’t you? Further, by his own admission, Cramer’s contract with CNBC actually prohibits him from short-selling.

Cramers and others have whined that they want the uptick rule reinstated to protect stocks and indexes from being attacked by short-sellers. This is a red herring, in my opinion. You can watch the tape on any trading day where sectors and stocks are being pummeled, and within even the shortest time frame, you’ll note plenty of upticks along the way down.

And, speaking of smoke-screens and red herrings, now Edward Jones is prohibiting its clients and advisors from trading in leveraged ETF products. It sounds paternalistic on the surface but masks the real agenda—they don’t want clients deviating from their high-fee plans sold to the masses door-to-door.

Many investors, retail and institutional alike, are day-trading leveraged ETFs. Whether they’re successful or not isn’t the issue. Many of these products are horning in on the action for options and futures traders. After all, options have caused more investor complaints and hardship than any ETF, leveraged or not. As a former options principal, I can say with authority that understanding options strategies is more complex and confusing than grasping the proper use of any ETF product.

Other ETF-haters include many in the mutual fund industry, especially those tied to the exorbitant fees generated and so-called “evergreen” income earned. In fact, it was the scandals caused within the mutual fund industry in 2002 and 2003 that turned investors to ETFs in the first place. ETFs have proven disruptive to costly business models, and those dependent on them, don’t like the growing ETF market one bit.

Are there poorly constructed, bad or ineffective ETFs? Sure, and they’ll be winnowed out and disappear over time. But their number pales in comparison to the many worthless mutual funds still being issued and tormenting holders.

Those promoting individual stocks dislike the growing ETF market because most recent asset flows have been to ETFs and not single-stock issues. No wonder those guys are upset!

Leveraged and unleveraged inverse ETF products allow sophisticated retail investors and financial advisors the ability to construct hedge fund-like strategies for themselves and their clients that were heretofore unavailable for these investors. ETF products exist to protect investors from the carnage of bear markets and to provide opportunity to profit in bull markets. So who in the hell are Jack Bogle, Jim Cramer, and now Edward Jones to tell such investors they shouldn’t or can’t have this protection, or benefit from these opportunities?

And, of course, regulators with little else to do, jump on the pile. State agencies are under pressure to justify their existence and defend their budget allocations in this era of poor municipal revenues. State regulators can be the most uninformed pests amid the regulatory environment. Witness the State of Massachusetts Attorney General John Galvin who is launching an investigation into leveraged ETFs and their marketing practices. It’s hard to imagine they’re not doing that with the more volatile and dangerous options markets. This guy is just grandstanding sensing a microphone and TV camera near. Anyway, the SEC is already on the case and they’re cracking down on sales practices making the Massachusetts effort redundant.

Despite the few--but loud-- naysayers, these products will continue to be used by thoughtful and disciplined investors to achieve portfolio protection and profit opportunity.

Comments

[Hedged In:]

Excellent article. This needed to be said -- and heard. Thank you Dave!

Jun 28 01:23 PM

[F. Bradeen:]

I love these leveraged and inverse ETFs. They allow me to hedge my portfolio and actually decreaswe risk. E.G if one needs to have a short position to hedge a long that he likes, he can lever it with a double, even triple inverse fund with 1/2 to 1/3 the funds needed for a simple inverse fund and now can be done in a regular IRA account. I agree with you, they put us small guys on a level playing field with the "black box" hedge funds who have been doing this for years.

Jun 28 01:30 PM

[athena:]

The best is when trading options on some of these... and put the trade on real steroids. Premiums are totally insane-good for writing calls or puts.

Jun 28 02:09 PM

[Salacious:]

I myself own holdings in some Vanguard mutual funds, but you can only be entertained watching their returns for so long. To take some risks, and have some fun, it's nice to be able to use a leveraged ETF to play the market.

Jun 28 03:11 PM

[helper:]

Very good article. As a casual retail person, these products have done more to level the playing field than anything since online trading became available. I am very satisfied making my own decisions and the likes of those you mention are doing nothing less than trying to drive me back into the slower, more expensive, more restrictive, crappy world of dealing with paid financial people.

Fair, open, and free markets are created and maintained best with rules that restrict front running, trading on non-public information, and then removing the rules that create friction between those that want to trade and the market they are trading in.

Jun 28 03:35 PM

[fed_alchemy:]

I quickly scanned down to see no ownership disclosure without reading seeya

Jun 28 04:57 PM

[Daniel Herkes:]

Thank you for a good summary of a complex issue. I believe the EFT makes a small investor a better investor. They also keep the paid brokers honest by offering an alternative. The older I get the more I understand that competition, though ruinous, is good per se. They spread the risks (of which there are many) and allow the non-machine trader the virtue of human intuition. I just wish my intuition was better . . .

Jun 28 06:01 PM

[JR Ewing:]

The SDS has saved me more than a few times, as a put seller being able to hedge quick make money on the way down and make it on the way back up has been key in this range bound market. And using the USO to short oil with its quirky contango issues in the first week on the month is big too. It cost a lot to learn these lessons - Thank you to all the Seeking Alpha writers and contributors who shine light and education on complex issues like these. Thanks Dave for all of the time that you put in week in and week out.

Jun 28 06:05 PM

[FreeMktFailure:]

Wouldn't this be a smart regulation; Make it illegal for typical stock brokers and financial advisors to market these products to individual investors without informing them of all the points made in this article. They should not be allowed to sell triple leveraged inverse ETF's as a pure long-term strategic position. The position should have to be part of a defined, explainable hedging or trading strategy. Furthermore, there should be questions added to the series 7 and 63, I think those are the ones new brokers get, I don't have them, that test a broker's knowledge of the products and their uses. It should NOT be illegal for individual self-managed portfolios to do whatever they want cause noones selling them anything. Online wins? Tough, read another book and answer a couple of questions hot shot. Brokers get better, more rational markets and prices. And less people pissed off and up-in-arms cause they lost all their money.

Jun 28 06:27 PM

[Riles:]

Appreciate this, Dave, as had given up on the leveraged and even single inverse, due "disproportionate" to expected behavior...but your emphasis on SHORT term holding is sound. Just rechecked and here's some, I think, valid numbers comparisons: YTD till March 9th S&P down 27.5%, while SH (single inverse) up 33.5%. Through 6/26, S&P down 2%, SH down 6%. For the Russell 2000, RUT to 3/9 down 32%, its inverse RWM up 40%, and through 6/26, RUT up about 2% while RWM is down 12.5%. Obviously not perfectly "proportionate" to "expected", but these are LONGER terms, we've had very choppy markets where "the math" is less forgiving on these (and especially for those margined!) and, as above comments and you note, these ETFs give a simple, cheap and risk limited way to hedge for the "little guy".

Jun 28 06:50 PM

[fjpenney:]

Amen. I use 2X ETF's and inverse ETF's to beat buy-and-hold by a wide margin with a minimum of trades. Here in Canada, Horizon Beta Pro constantly reminds its market that the 2X ETF's are rebalanced daily and the return they generate is path dependent.

Jun 28 07:19 PM

[Missing_Link:]

AMEN!!!

Thank you, David Fry!

I say this as someone who's recently lost over $100K -- a TON of money for a small investor like myself -- on leveraged ETFs.

I blame no one but myself for my losses. It's not the ETFs' fault. My losses taught me many hard lessons and forced me to learn what I was doing wrong. I will not make the same mistakes again.

Good investors know that leveraged ETFs are a short-term traders' tool and require careful timing to work properly.

Banning ETFs would be unjust and un-American. David Fry, thank you for standing up for capitalism and democracy!

Jun 28 07:37 PM

[JoeBren:]

How does a 73% return sound, that's what these inverse ETF's did for my portfolio in the last 12 months. Try getting that with a mutual fund.

[e-mail]

Jun 28 08:21 PM

[PCScipio:]

Good article, Dave, but what prompted it now? Bogle's recent criticism?

Jun 28 08:54 PM

[Ames Tiedeman:]

Well stated. These inverse ETF's are neither good nor bad anymore than a hammer is good or bad. They are tools to be used, but they must first be understood. Too many people suggest they are horrific because they have not a clue with regard to how they work.

Jun 28 08:59 PM

[storm999:]

leveraged ETFs and ETNs have been great for me. It gives me a chance to have half the capital at risk and get the same return. Also, you can hedge a position by taking the opposite side ETF during a rally/sell-off. I love em! If people abuse them so be it, people abuse everything.

Jun 28 09:01 PM

[steveowinlow:]

No disclosure? Perhaps that is because no specific security is mentioned in the article . . .

Jun 28 09:22 PM

[Stone Fox C...:]

Personally I don't have a problem with leveraged ETFs or even these flawed ETFs used now, but like any typical financial product they weren't marketed correctly. It was never pointed out by the products, but by bloggers and the like that if you hold these products for extended periods you'll always lose money. Its pretty absurd to have a inverse product that loses money in a brutal bear market.

Hey, its good for me as it just makes more people interested in help when you've got so many mine fields in the market.

Jun 28 11:33 PM

[sethmcs:]

EFTs are for gamblers. Not investors. I just have one question: Who is stupid enough to provide the leverage? The debt to make these things work. A sharp market move should result in a failure of one or more of these EFTs.

Jun 28 11:57 PM

[376602:]

Accidents happen -remember portfolio insurance, wide is the road that leads to perdition. Narrow is the escape window.


On Jun 28 11:57 PM sethmcs wrote:

> EFTs are for gamblers. Not investors. I just have one question: Who
> is stupid enough to provide the leverage? The debt to make these
> things work. A sharp market move should result in a failure of one
> or more of these EFTs.

Jun 29 12:32 AM

[corey mendel:]

Sounds like Seth has lost some money with EFT's, might want to try ETF's? Just saying....

Jun 29 01:15 AM

[DumbAss:]

They can't be traded long (eg from an IRA). Look @ the charts, since March 9, there have been no more than 3 long days on any of them (sds, smn, srs), so if you need 2 days for confirmation of a trend, jump in on the LOD on the 3rd day, hit the high (already lost momentum with zigzag drops) followed by complete loss of momentum, then gap down the next day. So if you try to trade them long (ignoring options), even during the market retracements we have had recently, hey have the potential to screw you every which way to Sunday. And if you make the lethal mistake of feeling bearish and therefore hanging on after the market has turned bullish again (not the first bullish day is usually testosterone-fueled), you are totally shafted.

Of course, if a little birdie tells you that tomorrow will be a 3% selloff, and the next day will be another 1.5%, then another birdie tells you its safe to jump in long again at the end of the second day, you are made. But that's not retail, that's insider stuff.

And another thing: Even the 2x does not have the capacity to hedge volatile stocks, which get hammered more than the market index during a retracement. And (ignoring options for a second), even if you put 50% of your portfolio into a 2x ultrashort in order to fully hedge, does this not mean you have to either move awful fast (like within a few seconds), or permanently sideline 50% of capiltal? As a retail investor, am I missing something?

Jun 29 02:29 AM

[DumbAss:]

With grammatical corrections:

They can't be traded long (eg from an IRA). Look @ the charts, since March 9, there have been no more than ~3 consecutive long days on any of the liquid ones (sds, smn, srs), so if you need 2 days for confirmation of a trend, then jump in on the LOD of the 3rd day, then hit the high (already losing momentum with zigzag drops) followed by complete loss of momentum, then gap down the 4th day. So if you try to trade them long (ignoring options), even during the market retracements we have had recently, they have the potential to screw you every which way to Sunday. And if you make the lethal mistake of feeling bearish and therefore hanging on after the market has turned bullish again (note: the first bullish day is usually testosterone-fueled), you can be totally shafted.

Of course, if a little birdie tells you that tomorrow will be a 3% selloff, and the next day will be another 1.5%, then another birdie tells you its safe to jump in long again at the end of the second or third day, you are made. But that's not retail, that's insider stuff.

And another thing: Even the 2x does not have the capacity to hedge a volatile stock portfolio, which gets hammered more than the market index during a retracement. And (ignoring options for a second), even if you put 50% of your portfolio into a 2x ultrashort in order to fully hedge, does this not mean you have to either move & swap out awful fast (like within a few seconds), or permanently have 50% of capiltal tied up?

Sorry if, as a retail investor, I am missing something...

Jun 29 02:46 AM

[cameroni:]

Absolute nonsense David,

I am no fan of Cramer by the way but he is correct in some of his complaints against ETF's and in particular inverse ETF's. You need to read the small print on each and every one very, very carefully before investing. They are designed with a general suggestion of performance along lines that on the surface make complete sense but on a closer look (or loss) proves otherwise.

I DO NOT RECOMMEND ETF's for novices. They are really very complex and do not usually mirror the market in an intuitive manner. They are an excellent way to lose money if you don't know the exact content and have all the time necessary to monitor all the aspects each entails.

This is one of the biggest sucker plays ever invented. I stand by all my earlier remarks on the subject. To any investor I would advise that they study and become intimate with individual companies and invest accordingly. ETF indexing is just a lazy man's approach to playing the market and losing money (the easy way, as in very quickly).

And finally, if you must use ETF's then do so judiciously and keep it very short term . Day traders territory only. High risk, high gain but also high loss. Use your head and read the details carefully before buying.

This one comment you made David sums it up nicely:


On June 28th 2009 the Author wrote:
"Leveraged issues should be used strategically and tactically by experienced investors over short periods of time, which may include day-trading and time periods of just a few weeks".

Jun 29 03:22 AM

[blahdeeblah:]

Few people are suggesting that the existence of these leveraged ETFs is inherently evil. However, since they are not appropriate for the average investor, they should not be marketed as such and should in fact have BIG RED WARNINGS on them for anyone who wants to buy them. Many people who recommend them, including on financial blogs, clearly have very little idea of the underlying math of these leveraged products.

There are posts which, to paraphrase, say "I believe that oil will appreciate - try the double-long ETF DXO". There's no mention of the fact that this not for a long (or medium) term investment in oil - just a vague claim that this ETF will do "twice as well as oil".

Furthermore, I doubt that many people who claim that are using these tools as part of their trading "strategy" are actually more than gamblers at the craps table who have convinced themselves that they are experts at a game of chance.

Jun 29 03:54 AM

[ecoco:]

“Absolute nonsense David” I hear strong words with no justification.
I do not see any sense in your comments Caeroni
“I DO NOT RECOMMEND ETF's for novices”, well I believe ETF’s are the ideal investment vehicle for novices who do not want to risk investing into company shares, mutual, hedge, products, etc.. They iron risk, offer diversification and give a wide choice in sector investing. They offer cheap and simple tools for playing the market that was only available for large institution and BIG money.
ETF have pulled the rug from underneath Mutual Funds and Hedge funds as ETF’s offer transparency and low cost investing. Their popularity is the envy of financial institutions who lost many investors having their figures burnt by not “Using their head and reading the details carefully before buying.”

“They are really very complex and do not usually mirror the market”, well do you have a better investment that mirrors the market, come on do you consider this as a reasonable remark. Show me a Mutual fund that really matched the market like SPY and many others with low fees, simplicity and LIQUIDITY. To me buying GE is far more complex than SPY.
“They are an excellent way to lose money”, this has nothing to do with ETF’s. Ask millions of investors who trusted many good and bad investment houses and bought poisoned products and funds that offered no TRANSPERANCY and EASY EXIT when things went wrong, how they wished they have invested in ETF’s. With all the sophistication and investment voodoo at hand, very few institutions managed to (be honest) give the investor better returns than ETF investing.
We have ETF’s for short term, long term, hedging and risk aversion, indeed these ETF’s made life easier for us NOVICE investors, but you can not say LAZY investors, they offered us protection against SOPHISTICATED investors who would have wiped us out as they did to the institutions they ran.

Jun 29 06:14 AM

[TradingHelp...:]

The problem is not that the man on the street doesn't understand these products. I don't understand what my doctor or lawyer says when they start articulating their industry specific jargon. I trust their professional judgement.

The problem is a lot of people in our industry still don't understand the products. There is too much generalistion, consultants trying to be advise on too many products. There should be more specialisation. More expertise albeit in narrower fields. The examination requirements should be focused on product channels not vague and basic industry wide skills. They expression shouldn't be "if you don't understand don't buy it". The expression should be "don't sell it - in fact don't even talk about it unless you are an expert".

Jun 29 06:57 AM

[Archman Inv...:]

I think the usual statements sums it up:

"Investing involves risk"
"Buyer Beware"
"Past performance does not guarantee future results"
Ect Ect.

You know what scares me more? The thought that like everything else, what starts out as a good thing, becomes an insane mess.
What's next? 5 times leverage? 6 times?

That's what scary. It has already been talked about that these 3X products are already causing end of day rebalancing that is causing the indexes to have absurd end of day moves.

Well like everything else in this country, we tend to wait until something becomes a disaster before we do anything about it.

Jun 29 07:36 AM

[daniel3582:]

On Jun 28 06:27 PM FreeMktFailure wrote:

> Wouldn't this be a smart regulation; Make it illegal for typical
> stock brokers and financial advisors to market these products to
> individual investors without informing them of all the points made
> in this article. They should not be allowed to sell triple leveraged
> inverse ETF's as a pure long-term strategic position. The position
> should have to be part of a defined, explainable hedging or trading
> strategy.

Oh, like, say... a prospectus? Like that sort of information? Any idiot who will blindly follow the advice of his broker in this day and age deserves to be parted from his money. The days of believing your broker ended sometime in the late 90's, friend. Welcome to 2009.

America's biggest problem right now is people who start sentences with: "There ought to be a law about...." or "Let's make it illegal to..." There is no backbone left in this country, none of that "do it yourself" spirit that made the people of this nation so innovative.

Jun 29 08:34 AM

[doubleguns:]

I whole heartedly agree with the part about 5-6X ETF's. However I think that the manipulation at end of day can not be thrown at the feet of the 3X ETF's. This market is manipulated by the PPT every day and that is the major reason that the market has such huge end of day moves. We did not have theseend of day moves prior to the collapse but we did have these ETF's. What has changed? The activities of the PPT that's what. IMHO.


On Jun 29 07:36 AM Archman Investor wrote:

> I think the usual statements sums it up:
>
> "Investing involves risk"
> "Buyer Beware"
> "Past performance does not guarantee future results"
> Ect Ect.
>
> You know what scares me more? The thought that like everything else,
> what starts out as a good thing, becomes an insane mess.
> What's next? 5 times leverage? 6 times?
>
> That's what scary. It has already been talked about that these 3X
> products are already causing end of day rebalancing that is causing
> the indexes to have absurd end of day moves.
>
> Well like everything else in this country, we tend to wait until
> something becomes a disaster before we do anything about it.

Jun 29 08:47 AM

[Archman Inv...:]

Double: I definitely agree with you there.

Though markets throughout history have had some sort of manipulation, the US stock market is now truly a completely manipulated market. You have hedge funds, investment banks (using taxpayer (TARP) money, money center banks, etc, manipulating the markets, the FED and treasury and to top it off, they are all helped by the never ending stream of outright lies by CNBC, etc.

We all know most average americans have no clue, none, as to what "really" goes on. Maybe its best they don't.

Lets face it, if average americans really knew, it would be much harder to make money off them.
(I am still trying to find the guy who bought my PMCS from me at $250 or my JDSU from me at $110 back in 2000) LOL.

Jun 29 09:28 AM

[Luck-o-the-...:]

David
Great article. I have been arguing this on thestreet.com for the past two months. I've had a lot of back and forth with some of the folks that you mention here, and the counterargument always steers clear of facts. Well written, and I not only support you in your article, but also agree with you completely.
Keep up the good work.

Jun 29 09:52 AM

[alajac:]

I can't believe that no one has noticed that the problem with the inverse ETFs goes for the unleveraged ones as well, since the percentage change for a given dollar amount down move of the underlying index (which would be an UP move for the inverse ETF) will always be LESS than the percentage change for an equal dollar amount up move. (Example: a move of an index from $80 to $100 is +25% (which equals -25% for the inverse, and -75% for the 3X inverse), whereas a move of the same index from $100 to $80 is -20% (+20% for the inverse, and +60% for the 3X inverse). So if the index just fluctuated from $80 to $100 and then back to $80, over and over and over, the inverse would lose 5% every cycle and the 3X would lose 15%.)Thus, over time, I'm pretty sure that all of the inverse ETFs are going to go almost to zero, with the 3X inverses getting there pretty dang quick.

Or am I missing something here?

Jun 29 09:58 AM

[Luck-o-the-...:]

alajac - You are assuming that the market goes up instead of down first, by saying the 3x inverses will get to zero quickly. All the leveraged ETFs will eventually get close to zero (would only reach zero theoretically if a single day goes moves over 33% for the 3x's or 50% for the 2x's). However, if you read the prospectus, the ETF providers can actually REMOVE all leverage if a market exceeds a certain % up or down in a single day to avoid a move to zero. Mathematically, if the big single day move never happens, they will approach zero, but actually never reach zero. You can keep cutting something in half over and over, and it will never be completely gone.
The problems you speak of in the 1x inverse, would happen with the 1x long, if you started at 100, and the first move was to 80, then back up, etc. This is just basic math, and the application of compounding.
Also, you speak of 25% moves like they happen in a single day. The movement of these leveraged ETFs becomes a function of not WHERE the index gets to, but HOW it gets there.

Jun 29 10:15 AM

[doubleshortetf:]

TWM, SDS, SDS and SKF allows me to "short" using my regular IRA and ROTH IRA accounts. It's leverage I can use to make bets against what I see as another sucker bull market in bear market.

My fave is TWM as Russel 2K filled with small and junks went up lot more than S&P and Nasdaq and like David says hard for the "boyz" to manipulate.

And if Cramer rants about it than gosh it must be hood and as for old man Mr Vanguard - it really must keeps him up at night since ETFs can crumble his empire of sort.

Jun 29 10:27 AM

[Larrysyr:]

David,

Excellent points. Thank you.

The problem is not ETFs as an investment choice. The problem is the marketing of investments.

The entire investment industry has been tainted by encouraging average people to invest in risky assets through 401(k)s. I have heard these products marketed as the best way to prepare for retirement because "over time, the stock market outperforms all other investments."

The uninitiated are then enticed to save their earnings through whatever mutual funds the plan offers with the promise of free money through employer matches. The problem is that when the market takes away 50% or more of the average person's account, as happened last fall, that person thinks they've been robbed.

Whether or not there's been corruption, mismanagement, or just bad luck, the problem is that the element of risk in investing has been under-emphasized in order to encourage retirement savings to get working for mutual funds.

ETFs are getting slammed for losing investors money. But the truth is that ALL investors lose money from time to time. If this were made clearer to the general public in 401(k) presentations, there might be less money in the equity markets, and more in less risky investments. That would be a good thing in my book, because there'd also be less of the whining you show in your beginning picture.

More regulation, particularly limiting investors' choices, won't help a bit. We just need to be clear to the uninitiated that you can lose money when you invest.

Jun 29 10:33 AM

[AndrewBaker:]

The products are there for those who want to use them. No-one has to get involved. I trade them because I like to, and I accept that holding more than one day, especially the 3x ETF, is that much more risky, and I accept that there is a cost for the leverage that results in price decay. I have no complaint when I lose on a trade, and I have losses as well as gains. Is there anyone out there who says they are bad and has actually traded them? And, if yes, is the antipathy due to heavy losses as a result of either not trading them correctly resulting in a loss or losses, or trading them incorrectly through lack of knowledge of their construction and purpose, resulting in a loss or losses?

I agree with and endorse David's point of view wholeheartedly.

And I'm still waiting for my FAZ to come really good ... !

Jun 29 11:05 AM

[David Fry:]

With regard to those leveraged issues perhaps declining to zero due to market conditions they'll have reverse splits undoubtedly.

Finally, no one's holding a gun to anyone's head to use these products or not.

Good luck everyone!

Jun 29 11:41 AM

[SageNot:]

Cramer???

Who listens to a jerk like him? CNBC has a very strongly worded disclaimer before & after he mouths off, deservedly so IMHO!

Bogel should retire like all the other "buy & hold" WS veterans who made a living ripping off those investors who held on no matter what. At least ETF's should give you a chance to compete with specialists & the Buy/Sell programs that often are fronted by other WS crooks.

Am I jaded, you bet, I left Wall St. in the late '80's, working their left me feeling dirty every night & look what's transpired since?

We need more David Fry's & lees Cramer's, trust me we do!

Jun 29 02:00 PM

[Luck-o-the-...:]

According to one provider, the bar set for reverse splits is around $2.50 per share (and a close maintained below that point for several days). I believe we saw the first "test" when Direxion just did a reverse split on their Daily 3x MidCap Bear fund (MWN), which was no where near zero, and not even that heavily traded in comparison to most of their other offerings. That appears to have gone smoothly, thus I would suspect we will see more and more reverse splits when these enter the single digits.

Jun 29 02:09 PM

[wundr:]

One of the biggest problems with individual investors is that they may buy a leveraged ETF without really understanding what it is.

They see 2x or 3x and think, "Hey, I can make a bunch! Two times more money by buying SSO than buying SPY, AND its CHEAPER! All I have to do is wait for the market to go up and I'll make twice what I would make with SPY!"

What they fail to understand, without proper DD, is that it is only twice the DAILY return of the change in the underlying index. Unfortunately, they hold it for an extended period and it doesn't perform like they thought it should have.

I do question a certain design issue associated with them. A close look could lead you to believe that they are made to trade to zero over time. A downward move can take more of a toll than an upward move benefits. Eventually the NAV nearly always declines over time. Its in the prospectus of many of them, often hidden in a potential gain chart. As long as you're only trading for a current trend (whatever time line you choose) you're fine. Has anyone found one that doesn't fit this declining NAV scenario?

Jun 29 02:26 PM

[Luck-o-the-...:]

wunder,
the basic design of ANY investment is that if it moves down, then it has to move up a GREATER % just to get back to breakeven. The design is what it is, it isn't flawed. The way investors are using them are flawed, misunderstood, or plain careless. People are going to use these regardless of the warnings. Look at alcohol, cigarettes, gambling, soda, sugar...i don't care what it is: People see what they want to see, and will ignore warnings, no matter how many we put out there.


On Jun 29 02:26 PM wundr wrote:

> One of the biggest problems with individual investors is that they
> may buy a leveraged ETF without really understanding what it is.
>
>
> They see 2x or 3x and think, "Hey, I can make a bunch! Two times
> more money by buying SSO than buying SPY, AND its CHEAPER! All I
> have to do is wait for the market to go up and I'll make twice what
> I would make with SPY!"
>
> What they fail to understand, without proper DD, is that it is only
> twice the DAILY return of the change in the underlying index. Unfortunately,
> they hold it for an extended period and it doesn't perform like they
> thought it should have.
>
> I do question a certain design issue associated with them. A close
> look could lead you to believe that they are made to trade to zero
> over time. A downward move can take more of a toll than an upward
> move benefits. Eventually the NAV nearly always declines over time.
> Its in the prospectus of many of them, often hidden in a potential
> gain chart. As long as you're only trading for a current trend (whatever
> time line you choose) you're fine. Has anyone found one that doesn't
> fit this declining NAV scenario?

Jun 29 02:33 PM

[wundr:]

True. Leveraged funds only trade percentages. Percentages that can add up to a quicker change in a short period of time. A quick 50% change in the underlying would drop the index in half. A 2x fund could, in theory, hit zero.
Do you think the small negative changes over time will eventually be more than the small positive percentage changes?
Be interesting to see what the NAV of some of theses funds in will be in 10-15 years.

That is probably why the best way to trade leveraged funds is take the short side.
If you expect the underlying index to go up short the inverse 2x; if shares are available.
Decay is less and a long term decline may be inevitable anyway.

Jun 29 02:56 PM

[Luck-o-the-...:]

I absolutely think that both sides, long and short, will approach zero over time. I agree on the shorting side, but it has to be done carefully since shorting does entail unlimitied loss, and even though they degrade over time, you could face a short term BIG runup before they do head back down. Inventory is tough, and the interest rates can be expensive. I've seen some cost as much as 15% per year to borrow, although they fluctuate a great deal from day to day.


On Jun 29 02:56 PM wundr wrote:

> True. Leveraged funds only trade percentages. Percentages that can
> add up to a quicker change in a short period of time. A quick 50%
> change in the underlying would drop the index in half. A 2x fund
> could, in theory, hit zero.
> Do you think the small negative changes over time will eventually
> be more than the small positive percentage changes?
> Be interesting to see what the NAV of some of theses funds in will
> be in 10-15 years.
>
> That is probably why the best way to trade leveraged funds is take
> the short side.
> If you expect the underlying index to go up short the inverse 2x;
> if shares are available.
> Decay is less and a long term decline may be inevitable anyway.

Jun 29 03:29 PM

[corey mendel:]

SageNot, couldn't agree more. How do we set-up a debate?

Jun 29 04:12 PM

[Luck-o-the-...:]

Cramer and I have had a running debate for one month on realmoney.com
Obviously, you know my stance, since his is very clear. Would love to see David join the fray!


On Jun 29 04:12 PM corey mendel wrote:

> SageNot, couldn't agree more. How do we set-up a debate?

Jun 29 04:22 PM

[slammer1:]

Could not agree more w/ Mr. Fry, and well articulated indeed. Both Mr. Emotional-Overthetop-W... Crammer and John Bogle (Mr. Only go long and Buy&Hold), who I otherwise have great respect for in other matters, either do not themselves understand these particular ETFs or they do, but nevertheless continue to make the ill-advised statements that they do, need to cease and desist from doing so, as it simply erodes their credibility or makes them appear to be emotional and ill-informed. These particular ETFs are what they and are meant for what they are meant. I myself learned a reasonably expensive lesson myself by going long the UYG ETF as a proxy for XLF, for example, and "holding" it for a month, being right as the financial rallied, but still not making any money. Having then read up on many of the academic and research papers that have recently been widely written both by academia as well as research analysts and well as the prospectuses themselves, I quickly grasped the fact that these are very "simply" very short term trading vehicles. Neither "evil" nor "angelic." And definitely not for the amateur day-trader or uninformed. That's all.

Jun 29 08:04 PM

[Luck-o-the-...:]

No sooner said and Direxion announced reverse splits for FAS and FAZ today...


On Jun 29 02:09 PM Luck-o-the-Irish wrote:

> According to one provider, the bar set for reverse splits is around
> $2.50 per share (and a close maintained below that point for several
> days). I believe we saw the first "test" when Direxion just did a
> reverse split on their Daily 3x MidCap Bear fund (seekingalpha.com/symbo...),
> which was no where near zero, and not even that heavily traded in
> comparison to most of their other offerings. That appears to have
> gone smoothly, thus I would suspect we will see more and more reverse
> splits when these enter the single digits.

Jun 29 10:36 PM

[johnnycash:]

Great article! I also learned an expensive lesson trading the FAZ Direxion 3x's ETF because I failed to read the fine print and blame nobody but myself. Looking back, I did not have a clue what these products were but wanted in on the action. I've never whined to anyone and since then took the time to understand their objectives. Although they are not for me, they are obviously for others - volumes are insane . The reason people bash them is because they lost a bunch of $ investing in them directly or they just can't accept the fact that they are here to stay and they will continue to disrupt indexes, individual equities, trends, etc.. Someone made the comment that ETF traders are lazy? What an absurd comment! Are currency traders lazy too? What about people who put their money in CD's because that's what they're comfortable with - these people must be dumb and lazy! Funny thing is is these dumb asses retired as planned and have cash to buy everything 50% off while their co-workers are putting in another 7 years. Main point is all these know it alls with opinions about 'evil' or 'lazy' investments/investors know much less than they think and actually have a lower chance of surviving as a trader due to fear of change and lack of openness to new ideas. Futures and options did not exist on day one either. Also, booms and busts are here to stay and if someone thinks they know what's going to cause the next one they should quit talking and start devising a plan to profit from it. And I'm perfectly aware of Cramer's success as hedge mgr but he's got a show to do. People don't watch him because he's laid back and agrees with everything. And talk about lazy, he chooses to make his millions by doing a talk show instead of investing in individual equities like a real man. Go figure.

Jun 30 12:14 AM

[Niner:]

"It was never pointed out by the products, but by bloggers and the like that if you hold these products for extended periods you'll always lose money." A quote from a blog.

A quote copied directly from the Direxion page. "Direxion Shares ETFs seek daily investment goals and should be used strictly as short term trading vehicles. Please read the prospectus and visit our Education Center before investing"

"...daily investment goals and should be used strictly as short term trading vehicles." Pretty much says it all to me.

Jun 30 01:05 AM

[Moto:]

I didn't see anyone mention that Morningstar has joined the bashing bandwagon. Although maybe nobody considers them a credible resource anymore because their subscription fees are so high.

Jun 30 07:59 AM

[Robert Mart...:]

Well said. The critics of ETFs are vested interests or have outright conflicts. The whiners doth protest too much, methinks.

Jun 30 09:51 AM

[KeemoSaabi:]

As an independent investment advisor these ETFs including the inverse versions have given me a cost effective ability to tactically rebalance my client's portfolios in sectors or asset classes that has enhanced performance and risk management. I agree with David's points and would add that the ability to sell Puts and Covered Calls on the underlying ETF has provided me with the tools to further enhance return and control risk.

Jul 01 09:38 AM

[irieblue:]

Go look up the definition of REG -T.. en.wikipedia.org/wiki/... and then take your foot out of your mouth... Turbo charged ETF's allow you to circumvent the Federal Reserve's rule for margin limits, thanks for playing now come up with someing more meaningful please...

Jul 03 07:09 PM

[Old Trader:]

I was heartened to read the comments of a few who used levered ETFs to their detriment, and were able to "man up" and admit to not fully understanding the perils and pitfalls. Fwiw, my personal experience with levered ETFs (SDS, specifically) has been all positive.
Disclosure: currently long SDS as a hedge

Jul 05 04:45 PM

[SCBob:]

Dave, thanks for saying it like it is. As for the debate, I got 20 on the Irish guy, trust me on this one, don't bet against him.

Jul 24 09:06 AM

[Barbarous R...:]

The thing to remember with leveraged ETFs is this. The daily rebalancing requires them to add leverage when they go up and reduce leverage when they go down (to maintain the 2x or 3x ratio).

Thus if they go down, a bigger lift in the underlying asset is required to recoup the loss.
And if they go up, they stand to lose more from a given drop in the underlying asset than before.

If altering the leverage daily in that pattern is not what you want as an investor, you're probably better served by using the unlevered ETFs and adding your own leverage.

Jul 24 09:15 AM

[geewhiz190:]

From my perspective (Financial Advisor with a large brokerage firm with retail accounts) I could not agree more with its content. I think the inverse ETF and ETFs in general have been on balance, very useful investment tools.

Jul 24 09:17 AM

[sentinelbrit:]

My bet is that not many people make money on leveraged ETFs. I can understand why some firms will not allow their clients to own (trade) them. Dave has been bearish for some time, he is an experienced chartist and if you had followed his underlying theme - you would have been predisposed to short the market - particularly a week ago when it looked like the market was going to break to the downside as the right side of the head and shoulders looked vulnerable. Who would have guessed that the market would be up about 10% since then. Now if you had bought ultralongs a week ago you would be laughing all the way to the bank! But my guess is that not many people did and those who did probably sold out too soon. Those who were long in their equity portfolio probably outperformed them.

Jul 24 09:49 AM

[DannyBoy29:]

Great article. The problem is not the leveraged ETF's but the fact people who do not understand what they are doing try to invest in them. These are trading vehicles not investments. I like to think we still have some sort of free market capitalism left and there is a demand for these products as is evident by the volume on them. People who buy them and do not understand what they are doing deserve to lose money. I use them effectively so don't punish me by taking them away b/c someone else is to dumb to learn what they are doing before buying them.

Jul 24 10:45 AM

[kkerr:]

There is usually at least one leveraged ETF article on seeking alpha each day, and this is probably the best one yet. It never ceases to amaze me how little people understand how these leveraged ETFs work over longer timeframes, which is indicated in several comments here.

I've written several articles on Leveraged ETFs and decay, and my entire blog (ad free!) is dedicated to leveraged ETF research. I am not an expert by any means, but I did write custom software to analyze how hypothetical leveraged ETFs would perform over decades. Here is an article, which would probably be best titled: "Decay for Dummies"

blog.quantumfading.com.../

I hope this helps... I am on a crusade to help spread knowledge for swing traders.
Kevin

Jul 24 12:18 PM

[Beyond Trading:]

Congratulations on the article; it's good to have people sharing opinions even if one has a different perspective which is not the case on this matter

Jul 24 01:23 PM

[Bill40:]

I guess traders rule the day. It seems these ETFs would greatly increase volatility. Volatility makes holding stocks less attractive which would be detrimental to the valuation of the markets long-term since the increased volatility will push more and more people out of holding stocks.

Jul 24 03:14 PM

[Gary Gallo:]

If you look at the biggest buy and hold winners over the last six months they are all 2X and 3x ETF`s. Let the pundits chew on that.

Jul 24 04:57 PM

[corey mendel:]

Gary, agree with you 100%

Jul 24 05:19 PM

[corey mendel:]

I'm still shaking my head. My intuition tells me you lost a substantial amount of money with ETF's? I bet you love options! Any advice? (chuckles)

On Jun 29 03:22 AM cameroni wrote:

> Absolute nonsense David,
>
> I am no fan of Cramer by the way but he is correct in some of his
> complaints against ETF's and in particular inverse ETF's. You need
> to read the small print on each and every one very, very carefully
> before investing. They are designed with a general suggestion of
> performance along lines that on the surface make complete sense but
> on a closer look (or loss) proves otherwise.
>
> I DO NOT RECOMMEND ETF's for novices. They are really very complex
> and do not usually mirror the market in an intuitive manner. They
> are an excellent way to lose money if you don't know the exact content
> and have all the time necessary to monitor all the aspects each entails.
>
>
> This is one of the biggest sucker plays ever invented. I stand by
> all my earlier remarks on the subject. To any investor I would advise
> that they study and become intimate with individual companies and
> invest accordingly. ETF indexing is just a lazy man's approach to
> playing the market and losing money (the easy way, as in very quickly).
>
>
> And finally, if you must use ETF's then do so judiciously and keep
> it very short term . Day traders territory only. High risk, high
> gain but also high loss. Use your head and read the details carefully
> before buying.
>
> This one comment you made David sums it up nicely:
> "Leveraged issues should be used strategically and tactically by
> experienced investors over short periods of time, which may include
> day-trading and time periods of just a few weeks".

Jul 24 09:05 PM

[TraderGM:]

Great article Dave! About time someone wrote something like this!

Jul 24 09:08 PM

[Jonathan Dang:]

Crammer and John Bogle, step to the side... Thanks David! I've read your blog for the past few years. Would be great if you wrote more articles! God bless!

Jon-

Jul 24 09:20 PM

[2old2care:]

Dave,
Thanks for the updated re-post.

Jul 26 12:44 PM

[SeeTheLight:]

Sadly, the argument against these products is "people are getting burned by them". That is true, but they are not for everyone. Perhaps we should ban motorcycles since they cause more operator fatalities than cars. Perhaps we should ban ARM mortgages since look at the trouble they caused.

First, standard long ETFs are very good replacements for mutual funds as they remove many of the annoying high fees and improve liquidity. As for the leveraged and inverse ETFs, they also have a purpose as Dave so eloquently described above, to use as short term hedges among other reasons.

Perhaps we should ban gambling like Putin just did because apparently people are not responsible enough to understand what they are buying. Let's face it, although people might get burned by these ETFs, they are introducing more people to investing and its no wonder that scares the establishment since they might be out of a job if the general public decides no longer to heed the advice of highly paid (overpaid?) so called "experts" and take control of their own finances. I can not think of anything more stupid than just handing my money over to someone promising future gains without understanding why or how these gains will be achieved and yet that is exactly what the general public has done for years with the mutual fund industry.

ETFs represent a threat alright, to the mutual fund industry and the concept that the general public is too stupid to manage their own finances and that they need experts to lose their money for them while charging them exorbitant fees.

Jul 29 02:15 AM

[ForLeverage...:]

This is the best article yet. Thanks Dave.

Jul 29 08:40 PM