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Avoid the Pitfalls of Leveraged ETFs

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Exchange Traded Funds can be an excellent way for investors to gain exposure to an entire asset class with a single trade. In the case of broad market ETFs, it’s possible to own a diversified basket of stocks, with minimal management fees, and that you can trade into and out of anytime you like – including intraday. Brokerage trading commissions and management fees are extremely low, so the transactional costs - or “friction” – of ETF investing is very close to zero.

If you want to be long (or short) a broad index, a sector, an industry or thousands of other classes and combinations of assets, an ETF is a great way to take your desired position in an effective and inexpensive way.

The advent of ETF investing was a boon to the average investor. It was also a boon to the companies that manage those funds. Though the fees collected are very small, the vast number of ETF shares outstanding became so huge that the trustees found themselves with very profitable lines of business.

It has been has been a win-win for the investing public and the trustees of the ETF funds. Though the actual Net Asset Values of the funds can’t exactly track the underlying benchmark indices, by buying and selling the basket of assets in the index as investors buy and/or redeem shares, they are generally extremely close.

Unfortunately, pretty much every time finance professionals see something that’s working really well, they want to multiply it – and the results are not always positive.

Leveraged ETFs

In the wake of Broad Index and Sector ETFs came another class of ETFs that seem to be similar, but can exhibit much different price behavior – usually underperformance of the desired results during times when things are going the worst.

The leveraged ETFs seek to produce 2 or 3 times the return of the desired asset(s) and some of them offer the ability to go short the asset instead of just long. It makes sense on paper. If you want to get long or short the price of a given asset and you’re very confident, why wouldn’t you want 2 or 3 times the exposure?

There are a few mechanical reasons why you wouldn’t…

To produce the leverage effect, the managers use derivatives – usually futures, but sometimes also options and swaps. To maintain the correct exposure, the basket of derivatives needs to be adjusted every time the underlying price changes. It’s not practical to adjust with every tick in price, so it usually happens daily.

If you own the “regular” S&P 500 ETF (SPY - Free Report) and the market goes up 1% one day and down 1% the next day, your net return for the period will be zero (minus a negligible amount of two days’ worth of management fees.) In a leveraged product, the manager will be forced to buy more long derivatives on the way up and sell them on the way down. Instead of breaking even, you will lose money even though the price of the target underlying securities didn’t change over the two-day period.

Depending on the speed and severity of the moves, that loss as little as a fraction of a percent, but over time, those losses add up. Leveraged ETFs “bleed” constantly. That’s why you often hear the advice that they can be acceptable short-term trading vehicles, but not long-term investments. If you’re right about a directional move over a few days, you can easily overcome the bleed effect. In the long run, you’ll have to be really correct.

The other factor is the “roll” (and this also applies to some non-leveraged ETFs that replicate long or short positions on commodities if they use futures to achieve the desired exposure.) The manager will typically own the contracts in the front month. When those contracts near expiration, they need to be replaced with longer-dated contracts.

Though the manager might have discretion over how and when to perform those trades, the professional trading public knows that at some point, several ETF managers all need to do a spread trade in which they sell out the expiring front month contract and buy the next month. The pros know how to take advantage of that knowledge, and there’s nothing illegal or even shady about how they do it.

Over a period of time heading into the roll, they sell the front month contract, pushing it down and they buy the next month contract, pushing that price up. Over the course of weeks, they can widen the spread between the contracts considerably, but their average price is much lower.

When the roll trade appears and the ETF manager wants to buy that spread, the futures traders are happy to sell it – at the newly inflated price that locks in a profit for them while closing the position. The ETF manager doesn’t really have a choice but to buy it at the market price.

It’s not risk free for the futures traders, but if they’re smart about the timing, it’s pretty close.

It also means that over time, the shareholder of the ETF has been paying more to hold the position than if he simply purchased either the asset itself or futures contracts. That effect is multiplied with leverage.

There’s also the final issue of expenses. Because of the additional effort involved in management, leveraged ETFs tend to have much higher fees than standard ETFs. It might only be 25 or 50 basis points or it might be 100bps or more, but it’s always money out of your pocket.

What to Trade?

Leveraged ETFs are simple to understand and they're convenient – you can trade them in your brokerage account just like shares of individual stocks. Trading futures and options is much more complicated and comes with different accounts and capital requirements. Keep in mind that in finance, there truly is no free lunch. Leveraged ETFs are a way to give some of your money to experienced professionals.

Don’t.

If you have a strong idea and want to trade something for a very short period, you can use a leveraged ETF and you probably won’t be giving away too much. If you want to buy and hold (or maintain a short position), it’s a much better idea to understand futures and options and be your own ETF manager.

-Dave

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