Leveraged ETFs: Used Intelligently, The Costs Are Tiny

| About: Direxion Daily (DUST)

Recently some articles have been published here on Seeking Alpha, and in the broader media like The Wall Street Journal and New York Times, about the inadvisability of investing in leveraged ETFs. The common theme is that they have high fees, and by readjusting their base of calculations daily they may over time erode the performance of investors seeking capital gains.

Integral to the expressed concerns is the assumption that investors only follow an asset-by-asset, buy-and-hold investment management strategy.

Indeed, that is a prevalent investor error, despite the obvious and repeated experiences that the strategy leads to decades-long portfolio-performance-damaging results. On a macro basis, one only needs to look at the price progress of SPDR S&P 500 (NYSEARCA:SPY) from the turn of the century to the current date -- a few pennies of decline on a $146 base, over more than 12 years -- a zero annual rate of gain. It's obvious there is a need for active, price-sensitive asset attention.

Besides that, there is a complaint that the ETF management fees of over 9/10th of 1% per year are much higher than a possible alternative of 1/10th of 1% in an unleveraged ETF. That's a lot like saying "Why pay for airfare to LA from NYC when you can go by bus for less?"

The rewards of active asset management come largely from compounding several shorter-term returns in a year onto the same capital, capital that buy-and-hold sterilizes for the year on a single (usually fluctuating) asset. The leverage structured into LETFs (leveraged ETFs) magnifies the payoffs encountered in that compounding.

Leverage, of course, cuts both ways. It may magnify the reward, and it may also magnify the risk. That makes finding a selection process that has a high "batting average" (profitable experiences as a percentage of all - including loser - positions) an essential consideration.

Where that can be done, the profit performance differences can get dramatic. Here is a current example, selected for its high impact, from many that present themselves daily. We regularly evaluate over 2,000 stocks and ETFs, based on the price forecasts implied in the hedging actions of volume market-makers.

Direxion Daily Gold Miners Bear 3X Shrs (NYSEARCA:DUST) is an ETF that came into existence in early December, 2010. It tracks, in an inverse pattern, the ARCA Gold Miners index, multiplied threefold (approximately) by derivatives holdings related to the underlier index.

DUSTs average daily absolute price change has occurred at 3.77% (377 basis points) which is HUGE on an annual basis. But of course it does not continue long in the same direction, so much of that noise cancels out. Much, but not all.

Because of the rise in gold prices (and in the index of gold mining stocks that it tracks) the geometric mean daily trend has been only -11 basis points per day. That's a mere -23 ½% annual rate.

So we intend to look for active management gains in an ETF whose prices have daily changes that are up, by count, as often as they are down, but the overall trend is down at a rate twice the growth rate often attributed to equity investments. That looks like a challenge.

We need some help, and for that we turn to folks that every day have to protect themselves from clients who have noticed that their stagnating portfolios lack adequate representation in the asset clearly outperforming almost everything else.

No, not Apple (NASDAQ:AAPL) stock. Gold related investments.

In the big-money funds' quest to put gold into their portfolios, the trading desk guys at these funds are looking for ways they can play the game without getting in the way of their employers' strategies.

As very street-savvy guys, they are attracted to anything that has DUST's volatility. Their information resources make them dangerous players for the market-makers to contend with.

So the market-maker pros are especially diligent about their hedges in DUST, probably beyond what the trading volumes would suggest. And what a time to be interested!

Gold shorts are on sale, because Dr. Bernanke has just "cured" the USA's (or at least the US stock market's) problem by attempting to drain an overhang of MBS (mortgage-backed-securities) - "Until those markets improve . . ."

As go stock prices, so go gold prices -- at least according to current market wisdom. The effects of unwinding this latest reality arabesque are kicked down the political time trail for a different cast of characters to deal with. "What, me worry?"

The time to buy things is when they are on sale. The bleaker the outlook, the bigger the recovery. But when dealing with inverse ETFs, the driving logic has to be reversed.

We're not anticipating higher gold prices from here, but likely lower ones. Perhaps of the type that drove DUST's price in May of this year from $45 to $75, when the London fixing dropped from $1660 to $1560. The spot price is $1770 now, up a fresh $40 on the Fed's Friday announcement.

Here is how the market-making pros have been anticipating the attentions of their clients for DUST's likely price ranges.

The present scene puts DUST into a "catch a falling knife" category. It presently has an upside concern by hedgers of $30.69, some 28% higher, and a drawdown exposure to $20.20, or -15%. As the pros see it, roughly twice as much upside as down.

So what has DUST's price done in the past, when appraised this way by these folks? The first step in that analysis process is to see where today's prospects lie in the ETF's array of past outlooks. Here is the distribution of their forecast balances, upside vs. downside, as measured by the Range Index, where current price is the percentage above a low forecast indexed at zero, and a high at 100.

With a Range Index of 34, the current forecast is right at the midpoint of prior outlooks. So, what are the odds of higher DUST prices at this level?

This picture shows them right at the 50-50 point of better vs. worse outlooks in the next 3 months. That doesn't sound too encouraging. But how much higher and how much lower might the prices be in that comparison? Is he glass half full or half empty?

Here is the way the size of the DUST price changes vary, as forecasts progress from optimistic to balanced and then to pessimistic.

It turns out that the better outlooks comprise about 2/3rds of the higher prices and only 1/3rd of the lower ones, so twice as many of the +20% gains as the -10% losses still leaves a +10% mix. But the view from the dark side reverses things, and losses get more frequent, and larger, so the mix turns to a -6% result.

Netting the odds and the payoffs provides an integrated picture and eliminates the details.

Still, the conclusion remains the same: This is a poor time to make a commitment, because the leverages involved are so substantial and the differences in potential results are both exciting and scary.

Just a few days ago, with DUST's Range Index at 23 and a price of $31, the upside forecast sell target of $40+ appeared to be reachable easily. Out of 78 prior forecasts at least that attractive, 95% came up with a profit, and including the other 4 losers, average gains of over +27% were achieved in six weeks and a day, typically. That's an annual rate of +580%! It may yet be accomplished.

But today, at a DUST price of just under $24, the average gains of 182 prior forecasts at least this good still average +23%, and 7 out of every 8 were profitable. With these forecasts it took a day shy of 7 weeks to reach closeout, so the annual rate drops to only +354%.

Yet, if fear takes over and convinces the investor that even worse things are ahead for the entirety of his/her holding patience time limit, then the timid could be in for -10% losses or worse in, say, 3 months. That would be an annual rate approaching -35%, which would take more than a +50% annual gain to make whole.

In this case of particulars, this elaborate analysis results in more brain fatigue than in likely greed satisfaction. But it also sets the stage for reacting to near-time developments in both market prices and in professional prospect appraisals. If the expectations turn up and push the Range Index lower, then subsequent prices may become greed feed - if fear loses its appeal and positive action takes over.

And it brings us back to the original premise that timely decisions often overwhelm the tiny costs involved in what can prove to be extremely able and rewarding (or punishing) active investment vehicles. Would you pay (less than) 1% to make +20% or more?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.