Dave Fry: Thoughts on Leveraged ETFs

by: David Fry
As a starter for our upcoming live discussion on leveraged ETFs (Thursday at 2pm ET), we asked Dave a few questions regarding these products:

1) How, if at all, do you use leveraged ETFs in your own portfolios?

At the ETF Digest, we’ve recently launched an all leveraged ETF program for Dave’s Special Portfolio. In it we’ve broken down the current group to a dozen that are currently popular based on performance and liquidity. At the same time, we keep another two dozen or so in reserve to bring out as interest and liquidity build. Our approach is very short-term, with holding periods of a day or so if unsuccessful, to no more than two weeks if successful.

We try to incorporate as many uncorrelated issues as possible; however, in the current market environment, few in that category are available as many sectors are trending in the same direction.

It’s too soon to say how successful this will be, but it’s only for the most aggressive traders.

2) Do you see any significant tactical differences in the approaches of the leveraged ETF providers (ProShares, Direxion, Rydex) in terms of composition or methods of capturing the desired return? Do you prefer certain approaches over others?

In addition to ProShares and Direxion, we use DB commodity leveraged ETNs in the same manner. The more liquid issues are always the best to use.

3) Leveraged ETFs have been scrutinized all over for only being appropriate for short-term traders, due to the daily reset and problem of longer-term compounding. This summer, FINRA issued a direct warning to RIAs about the use of these ETFs in longer-term client portfolios. Do you think the leveraged ETF providers have done an adequate job in explaining these products? And do you think they are commonly misused by RIAs? Misused by retail investors?

Everything gets misused in our business, whether mutual funds, stocks, commodities, options and so forth. I don’t think issuers need to play nanny to investors, but should lay out the risks. Clearly, leveraged issues have been the low hanging fruit for regulators and the media to single-out as “evil” during the bear market. However, since markets have been rising, critics have been completely mute as the “bullish bias” remains a fixture for the financial media. They’re okay when markets rise - but not when markets are going south.

The FINRA warnings are a smoke screen, and I say this as a former FINRA Arbitrator. Even sillier have been restrictions by many wire-house firms on using “unleveraged” issues. ETFs like SH are the most innocuous and yet effective way for the average investor and financial advisor to hedge their market exposure. The main reason, other than the false “we’re looking out for you” reasons, is to prevent advisors and investors from breaking from their carefully fee-laden financial plan and actually “trading”. You are not permitted to sell with these plans. It’s like a penalty for an early withdrawal from a 12-b1 fund.

Add to this recent interference from the CFTC regarding commodity position limits on some ETFs and they have matched FINRA in their regulatory sector. Products like oil ETFs had a regulatory exemption letter for position limits. Investors proceeded with confidence in the durability of such a letter. But, again, politics of “we’re doing something” enters in and it’s easy pickings of more low hanging fruit for regulators.

What do the operators of these funds then do for investors? They turn to the more expensive OTC market to accomplish what is denied by CFTC. Who benefits? OTC trading desks at a few large firms like Commissar Gensler’s former firm, GS. So, the motto of regulators here has been “break it first and fix it later”. It’s a great disservice to innocent investors.

4) What are your thoughts on MacroShares' leveraged Housing exchange traded products (DMM, UMM)? Are these likely to face the same issues as the MacroShares oil products? If someone has a large percentage of net worth in home equity, would DMM make sense as a hedge against home prices falling?

I don’t use them.

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