Credit: Shutterstock photoLeveraged ETFs, it seems, are back in fashion. Following the stock market crash in 2008/9 “leverage” was a dirty word. In too many instances, while markets were booming, small investors were encouraged by advisors to invest in funds designed to give 2 or 3 times the return on a particular index or product. What was not properly explained in many cases was that these products were designed for traders rather than long term investors and, along with the high returns, carried a high degree of risk.
When the market collapsed, a lot of people got burned and lawsuits abounded. By the time I started my short stint as an advisor at a Wall Street firm, we were forbidden from using leveraged ETFs in customers’ accounts. Over the last few years though, as ETF use in general has expanded, leveraged products have made a comeback.
According to a Bloomberg article from October of last year, about 4 times as many leveraged ETFs were launched in that year as compared to 2014. Is that a good thing for investors, or a sign of the coming Apocalypse?
There is no doubt that leveraged funds have their place. With my current focus on energy products I use them frequently, particularly UWTI, DWTI, UGAZ, and DGAZ the three times leveraged bull and bear WTI and natural gas ETFs.
However, I have decades of experience in dealing rooms, so risk assessment and control is second nature to me. For the average investor, they offer a great opportunity in certain circumstances, but it is important to know how they work and the risks involved.
First and foremost, a statement of the obvious; if leveraged ETFs offer the prospect of two or three times the return on an index or commodity, they also result in two or three times the losses if the market goes against you. As obvious as that may sound it was a lack of full understanding of that that led to so many problems during the recession.
If you use these products it is important that you have something in place to control that risk. I would never buy one without placing a firm, GTC stop loss order to limit potential losses. Stop losses are not perfect as they are executed at the next available price if your level is hit but they do stop you from running a position into the ground.
By using stop losses that limit you to a maximum risk of, say, 10 percent of capital invested and having a target price where you will take a profit you also effectively limit the time that you will hold a position in these products, which brings us to another important risk factor: Leveraged ETFs are designed for short term use.
They use futures to achieve leverage and that distorts returns over time. Most futures contracts trade in a state known as “contango” in which contracts with longer settlement dates are more expensive than those with shorter dates. That means that each time approaching expiration necessitates selling an expiring contract and buying the next one out the fund incurs a small loss.
If you add the fees that are charged to cover the expenses and profits of the issuing company to that built in loss, it is fairly obvious that if the underlying market or product doesn’t move you will lose money on these ETFs. Those factors also mean that profits will usually be a little less than the stated two or three times the move in the underlying product, while losses will be slightly more. The longer you hold the ETF the more exaggerated that differential becomes.
Put all of this together and several things should become clear. Leveraged ETFs can be useful in a couple of ways. Products such as SDS, a 3x leveraged Bear S&P 500 ETF, can be used for short term portfolio insurance if you fear a correction in the market, or leveraged commodity ETFs such as those mentioned above, or NUGT and DUST which offer a leveraged play on gold, can be used for short term bets on commodities without having to open a futures account.
That, however, is about it. They are not suitable for long term plays, nor should they be used by anybody who either doesn’t understand, or isn’t comfortable with, the enhanced risk involved. As long as that is fully understood this time around, then the proliferation of leveraged ETFs just means that there are more tools for smart traders and investors, and is not a cause for concern.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
