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Leveraged ETFs - Caveat Emptor

PinnacleDigest.com


We all know buying stocks with leveraged money is a dangerous game. Why isn’t the same said for investing in leveraged ETFs?

Leveraged ETFs (exchange-traded funds) are some of the most sophisticated financial instruments available to the retail investor. In many cases, investors really don’t have a clue how they work and the best way to play these crazy things.

Leveraged ETFs have been around for 20 years but they only hit the mainstream in 2006 after the SEC spent several years reviewing their merit and if they were suitable for the investing public.

By 2008 leveraged ETFs were taking off, in parallel with the market crash. The reason for this was simple. Investors couldn’t make money off the stocks they owned because they were falling from the sky. The lure of making 2 times (and even 3 times) daily index returns was too tempting. It was the one thing that made sense to investors. They could make money in a bull or bear market and at the same time, make two or three times the return of the index or commodity on a daily basis. It sounded wonderful, especially since everyone had just lost a fortune in the crash and was hoping to make their money back quickly with these heavenly products...

Well, little did most investors know, these leveraged ETFs were not as wonderful as they first appeared.

Leveraged ETFs are designed to give investors a greater return (typically 2 or 3 times) than regular long or short positions. So, in layman terms, if you were to buy a leveraged ETF (long) which tracked the S&P 500 you would get 2 times the daily return of what the S&P 500 did - at least that’s what they are meant to do. If the S&P increased 2% on Wednesday, theoretically, if you were long an S&P leveraged ETF, you would make 4% on your money. Sounds very simple, but it is far from it. And this is what investors need to realize before they get involved in such financial products.

The risk behind these products lies in the name: LEVERAGED ETFs. Anytime leverage is involved in investing, risk is multiplied. Never forget that. When you borrow money to invest, you are subject to double risk. The risk of losing on the investment, and the risk of servicing the interest and debt taken out to pay for the investment. Same applies for leveraged ETFs. Let me explain.

Maintaining a constant leverage ratio, typically two-times the amount, is complex. Fluctuations in the price of the underlying index change the value of the fund’s assets, and this requires the fund to change the total amount of index exposure.

So, let’s say, for simplistic purposes, a leveraged ETF has $100 million in assets (cash invested from investors). It must then have $200 million of index exposure in order to provide investors with double the return on a daily basis. How does it get that $200 million? The fund borrows it. And when the index rises or falls, it is a constant rebalancing act. If the index rises 1% in a day, the fund now has $102 million (double the return  - 2% of $100 million) in assets (cash invested). But, in order to make sure it has double the exposure for the next day, the fund must now borrow more money because its assets have gone up. So, instead of borrowing $200 million, it now has to leverage $204 million. Sounds backwards doesn’t it? The more the fund gains, the more it borrows. Isn’t the purpose of investing to create wealth and borrow less? I know that is a very elementary example, but it proves the point that these things are toxic in nature. Let me explain what happens when things go the other way and what that does to participating investors.

Now that the fund had a winning day and has gone from $100 million in assets to $102 million and from $200 million leveraged to $204 million leveraged, what happens if it loses the next day and volatility kicks in?

The next day roles around and the index being tracked loses 1%, meaning the leveraged ETF  should lose 2%. Where does that leave the ETF in terms of net asset value? Its assets (cash invested) drops to $99.96 million. But wait, if it gained 2% the previous day and lost 2% today, shouldn’t it be right back where it started at $100 million. Unfortunately not; thus the danger in these instruments. But that’s not even close to where the danger ends if you bet (bet being the operative word) wrong. What happens to all the leveraged money? That $204 million has now lost 2% as well which leaves its worth at $199.09 million. So now the fund has to pay off that outstanding amount (over $4 million) it just lost in leveraged money which creates even more pressure on the unit price. So in reality, instead of the ETF losing 2% that day, it likely will lose closer to 3% (that extra 1% is just hidden, temporarily).

But wait, there is more expenses taking away from your profit..or adding to your losses.

Like all funds, these leveraged ETFs have what is known as management expense ratios (MERs). This is what the fund unit holders pay to the manager who controls the fund and balances it out daily. Typical MERs are around 1% annually (this can add up). But wait, there’s still more expenses investors must pay for...

Everyday the fund manager has to rebalance its holdings depending on what the market did. The fund manager is constantly buying and selling derivatives to maintain a target index exposure. I explained this above. But what I didn’t mention is that buying and selling derivatives to maintain index exposure has transaction fees associated with it. Who pays for these fees? The unit holders do (the investors in the ETF). Yet another expense hidden in the fine print. This takes away even more from investors profits...or adds to their losses.

I’ve tried to keep it as simple as possible when explaining how these crazy things work. I hope I’ve done a good job at scaring you away from holding these financial products for the long-term. Too many unsuspecting investors (and they are part to blame) have seen their capital crushed by holding onto leveraged ETFs.

There are only two ways I would play leveraged ETFs. The first would be to day trade them. And I mean DAY trade! Do not hold onto them overnight or your risk just multiplied. And make sure, unless your a pro, that you’re using only fun money (money you can afford to walk away from) because leveraged ETFs are incredibly risky.

The second way I’d play them is to short them. Leveraged ETFs are the best long term capital eroding investment out there. Check this example out. Let’s look at the chart for the leverage ETF by Horizons BetaPro which is long natural gas - HNU ( I use this example because it is a very popular one here at Pinnacle).

Take a look at the 1 year chart for the Price of Natural Gas:

 



Take a look at the 1 year chart for the Price of HNU, the ETF which, in theory, is suppose to give investors 2 times the daily return natural gas does:

 



I rest my case...

The reason I wrote this blog is to inform all Pinnacle members of the dangers in holding short-term financial instruments for the long-term. It is my belief that these leveraged ETFs should only be purchasable by accredited investors as they are highly sophisticated and hide much risk unrevealed to the investing public.

If your a day trader, then by all means, these could be great opportunities for you. However, judging by how quickly new leveraged ETFs are popping up, I’d say there is a lot more than just day traders buying these things and that concerns me.

I fear the exchanges, brokers and fund managers are making far too much money off fees and commissions from the purchase of leveraged ETFs by retail investors, and they aren’t examining the dangers these products have created.

With the markets dipping down once again and becoming mildly stagnant, I fear we will see another rush back into these ETFs as a way to make a quick buck.

There is no such thing as a quick buck in the stock market. Caveat emptor.

All the best,

Aaron

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Disclosure: no position