Written by: Chuck Jaffe | Raging Bull
The vast majority of people who tell you not to invest in leveraged and inverse exchange-traded funds have never owned or traded one.
But in the current discussion over whether the Securities and Exchange Commission should approve two new ETFs seeking to quadruple the daily return of the U.S. stock markets – a move that critics say would open the door to even more highly leveraged products – the lack of trading experience translates to a lack of understanding.
Until recently, I would have been in the just-say-no camp for leveraged and inverse ETFs. They always seemed to me like illegal drugs, where I understand the side effects and impacts and can accurately discuss the downsides without ever having partaken myself. And no, I have never even sniffed at a leveraged ETF.
Since recently joining RagingBull.com as editor, however, I have watched expert traders use leveraged ETFs like an art form, finding ways to gain an edge and make money on days when the market has been mostly flat and lacking volatility.
What’s more, these traders aren’t using leveraged ETFs in the ways that make them bad on paper. They’re not acting like a badly addicted gambler trying to double down in a casino.
So when I see the SEC reconsidering its approval of the new ultra-leveraged ETFs, I wonder whether the agency and the critics are protecting the public from a real danger, or trying to protect investors from themselves.
Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track; if the Russell 1000 Financial Services Index gains 1 percent in a day, for example, the Direxion Daily Financial Bull 3x Shares (FAS) should deliver roughly 3 percent.
Inverse ETFs or short funds move in the opposite direction from the benchmark they track, and leveraged-inverse ETFs ("ultra short" funds) try to do that in multiples. Thus, if the Standard & Poor’s 500 falls 1 percent in a day, the ProShares UltraShort S&P 500 ETF (SDS) would be up roughly 2 percent.
It’s confusing, especially because investors miss out on the fact that the funds are pegged to daily returns. When held for longer than a day at a time, your mileage may vary, because the time decay on the options needed to create these funds comes into play and takes a bite out of the numbers.
There are now over 200 leveraged ETFs holding almost $45 billion in assets, meaning investors can play hunches in everything from single countries like Brazil to commodities like gold to industries like energy and everything in between.
They can also get burned by the math if they hold on too long waiting for their hunch to pay off.
That’s one reason why last year the SEC proposed rules limiting the use of derivatives and leverage in mutual funds and ETFs, a move that could kill off new issues if not the entire category.
When the SEC in May approved the ForceShares Daily 4X US Market Futures ETFs – which come in long and short flavors, each betting on financial contracts with returns tied to the S&P 500 and trying to deliver returns four times the daily performance of those futures – it appeared that any move to rein in leveraged funds was over.
Shortly thereafter, however, the SEC reconsidered its approval; currently, the launch of the new funds is stalled.
The same experts who have never traded these products called that a triumph and a return to common sense.
When I re-read the SEC’s investor alert about leveraged and inverse ETFs, it was clear that they were issuing a warning to buy-and-hold investors – completely unsuited for these products – rather than for people who might trade them.
Leveraged products are power tools. The traders I talk with each day are looking at charts and analytics for specific entry and exit points, they’re putting stop-losses in place, they’ve calculated a risk-reward ratio that is in their favor, and they are on top of the trade minute-by-minute. They use leveraged funds leverage to squeeze more out of small, quick moves lasting a few days at most, and use ordinary index ETFs when they see something big and long-term.
If you’re playing a hunch with a leveraged ETF rather than trading a strategy based on strategic analysis, you’re the dumb money at the table.
The problem at that point isn’t with the leveraged or inverse ETF, it’s with you.
I’m not sure regulators can or should protect investors from their own stupidity.
The argument against approving the new ETFs and expanding leverage, therefore, shouldn’t come from folks who have never traded them, but from people with skin in the game.
Here’s where I was surprised. Expert traders don’t think these products are necessary; if they want to protect the public from mishandling new products – and they do -- that speaks volumes.
Jeff Bishop of TopStockPicks.com acknowledges that he would use the FocusShares products – once approved, opened and showing sufficient liquidity – for the extra leverage, but noted that “4x products are just a bad idea in general. There's no true investment reason why they should exist; it is just for day-trading junkies.”
Most people, Bishop noted, won’t use the new products the way he does. “They’ll buy-and-hold them for way too long. These 4x products, if approved, are going to cause a lot of unsuspecting people a lot of pain.”