One cannot be a successful investor without first understanding what not to do. Inaction, as it were, creates the opportunity for positive action.
So what should investors be "not doing" today? Ah, now we're getting somewhere!
Perhaps the most pernicious investment vehicles out there today-by which I mean they seem designed almost solely to separate investors from their money-are the rapidly-growing crop of "niche" ETFs. While not frauds in the vein of Madoff and Enron, at best such offerings charge fees for exposure investors could easily acquire themselves, and at worst seem nothing more than poorly-conceived marketing schemes. In fact, some of the latest offerings-the recently-launched Spirited Funds/ETFMG Whiskey & Spirits ETF, with the cheeky ticker WSKY, jumps to mind-seem to openly mock buyers with their ridiculousness.
But by far the worst are the increasingly-fashionable leveraged ETFs-offering leveraged exposure to the overall market, high-beta sectors such as biotechs and gold stocks, and even the volatility…of volatility.
Let's dive in.
First, it is worth mentioning that of course such offerings have no place in a Zen Strategist portfolio, and some may wonder why even bother to discuss them here. Well, two reasons. First, my guess is most people don't realize just how dangerous these vehicles are, and second, their problematic nature actually opens the door to what can, in the right situations, be extraordinarily attractive opportunities.
In other words, once we know what not to do…
But first, the problems.
Leveraged ETFs are relatively simple to understand, offering 2X or 3X the daily return of a specified index. The "daily" part is important, as one of the more common mistakes investors make is to believe these vehicles will provide double or triple the index return over any time period. Emphatically not true.
In fact, leveraged ETFs, given enough time, all go in one direction-down. This is due to the nature of volatility. Consider the following example.
Janet Yellen gives a hawkish speech, thus worrying investors about interest rate hikes and causing gold stocks to crater, falling 10% in a day (for illustrative purposes, assume the VanEck Vectors Gold Miners ETF (GDX) falls from 100 to 90). The next day, Yellen "walks back" her comments, causing markets to reverse their moves, with GDX rallying 10% (from 90 to 99). So the gold stock investor is down, but not by much, while someone short gold stocks is up the same 1%.
Now consider the popular-and wonderfully named-leveraged gold stock ETFs from a firm called Direxion, which offer 3X daily exposure to GDX. The Direxion Daily Gold Miners Index Bull 3x Shares ETF (NYSEARCA:NUGT) went down a whopping 30% the first day (from 100 to 70), then rallied 30% the next day to…91. As you can see, despite the index having barely budged, the leverage factor has been ruinous to the long gold investor.
But wait, it gets worse. The owner of the Direxion Daily Gold Miners Index Bear 3x Shares ETF (NYSEARCA:DUST) (perhaps my favorite ETF name) was dancing in the streets after day 1, with his fund soaring from 100 to 130. But after day 2, the fund not only retraced that gain, but fell all the way to…91!
(This is reminiscent of the old Wall Street saying about bulls making money, and bears making money, but pigs getting slaughtered.)
Basically this is a math issue. Indeed, leveraged ETFs turn one of the most useful ideas in finance-that the easiest way to boost long-term returns is to lessen volatility-on its head.
So why does anyone own these things? Well, for the chance to make a quick buck, of course! And it is true that during periods of trending markets the leverage factor works in your favor. In the prior example, if gold stocks fell an additional 10% on day 2, the DUST investor would be up an astounding 69%, compared to about a 19% gain for someone short the index.
Let's take a look at those potential gains. (And yes, obviously I am cherry-picking the data to make a point-it is extremely unlikely anyone, anywhere, actually achieved these returns…)
From Sept. 21, 2012 to June 26, 2013, as gold stocks cratered by nearly 60%, DUST soared from about $20 a share to over $160, for an astonishing 633% gain…in nine months! (As one of my ex-colleagues used to quip when he made a short-term gain: Do you realize what that is annualized??)
Clearly, then, this is the appeal of leveraged ETFs. However, about that cherry-picking……
Indeed, pretty much all leveraged ETF charts look like this, at least on the right. To borrow from Tolstoy, all standard ETFs are alike; each leveraged ETF goes to zero in its own way.
The reason for the different values, by the way, is that the stock has since reverse-split twice, so one share today is the equivalent of 25 shares back in the halcyon 2012-13 period. Or said another way, had you bought 25 shares at the $160 peak (about $4000), you would today have one share worth…$40.
One more example, which makes the point that, my cherry-picking notwithstanding, these investments can be losers even if you knew the market direction ahead of time.
Consider 2015, when the GDX fell 27% for the year. Must have been a great year for DUST, right? Umm…not so much.
OK, hopefully by now we all agree these are vehicles to be avoided. But can we somehow turn this to our advantage?
The obvious question is…why not just sell these short? This is indeed a valid strategy-and can, done correctly, fit the Zen Strategist framework-but you need to pick your spots. Take a look at the first DUST chart to remind yourself of the dangers therein.
Another alternative, again in the right situation, is to either buy long-term puts or sell long-term calls. Generally call-selling is the more attractive (ahem) option, due to the high premiums on both. In other words, the high volatility on the ETF drives up option prices, which hurts in the case of buying puts, but helps if you are selling calls. This would be a wash, except…in contrast to typical option trades when more time is more valuable in both directions, with leveraged ETFs this is only true for puts. Remember the 2015 DUST chart, as well as the "since inception" chart.
My preference for these trades is always to choose the longest maturity and highest call price to minimize risk. For example, right now the January 2018 $90 call (the right to buy the stock at $90, expiring Jan. 19 of next year) is selling for about $8. With the stock at $40, this means you need it to rise less than $50 (or 125%) for the option to expire worthless. And of course it could rise by $57 and you would still make money…but not much.
Further, you need to have enough capital-and fortitude!-to withstand any short-term spikes. Margin rules are somewhat complicated, but the amount of required capital increases, sometimes dramatically, as the stock approaches the strike price. Currently it will "cost" you about $400 in capital for each call sold (for proceeds of $800), so the potential profit from this trade is roughly 100%. Not bad for a nine-month investment!
However, from a Zen Strategist perspective, the time is not yet right…but seems close. Gold stocks have been falling lately-due mainly to worry about rising interest rates-which has pushed DUST from $25 to $40 in less than a month. For context, it topped out in mid-December at $68 a share. GDX, meanwhile, is at about $21, below its December level of $25 and September peak of $28, but well above its early 2016 trough of under $13. And with the potential that a Fed hiking cycle (and/or strengthening economy) could torpedo the price of gold and gold stocks, there is a bit too much risk here for my taste.
This, it is worth noting, is not unusual for the Zen Strategist method, which I sometimes liken to the poker game Texas hold 'em. For those not familiar with it (although I think all investors should play poker…) hold 'em is a game where each player gets two cards, then makes the best possible hand using those along with the five "community" cards on the table, which are dealt 3 (flop) 1 (turn) 1 (river).
The hardest part about hold 'em is the patience required. While televised poker makes it seem as if every hand has multiple players involved and an exciting showdown at the end, in reality the game is a long slog of waiting for good cards, then playing them to the hilt. Or in baseball terms, letting a lot of "good" pitches go by…waiting for the fat pitch.
 Margin rules vary by firm, and you should always check with your broker before placing a trade.
 Although this is not always the case-google "Doyle Brunson" for the classic counterexample.
Disclosure: I am/we are short DUST.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.