Leveraged ETFs…Too Much Adrenaline?

July 15, 2009 at 4:00 am Leave a comment

Do we really need extra levered ETF risk?

Do we really need extra levered ETF risk?

Isn’t the market volatile enough without leverage? I believe the vast majority of individuals have plenty of adrenaline in their daily investment lives without the necessity of exotic inverse ETFs (Exchange Traded Funds) or other leveraged investment vehicles. FINRA (Financial Industry Regulatory Authority), the largest regulating body overseeing U.S. securities firms feels much the same way. Many of these ETFs seek to earn a daily return double or triple a designated index – the inverse instruments strive to mirror the return in the opposite direction.

Read WSJ Article (FINRA Urges Caution on Leveraged Funds)

No doubt, many exchange traded funds have some key advantages over actively managed mutual funds such as lower costs, tax efficiency, and improved liquidity; however most investors have no business in trading these crazy leveraged gimmicks. For example, I wouldn’t recommend average investors speculating in the Direxion 3X Inverse Financial Bull (FAS) ETF, which was down more than 95% in its first four months of existence. Do yourself a favor and heed the advice of stuntmen that advise, “Please, do not try this at home.”

FINRA conveyed this sentiment in a recent notice:

“While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective.”

 

The Wall Street Journal article goes on to show a return example of how three different funds performed (vanilla index fund, double long fund, double inverse fund) under alternating positive and negative +/-10% day scenarios.  After 60 days of alternating up +10% and down -10% on an initial investment of $100, the index fund ended at a value of $40.47 while the double inverse funds finished worth a meager $2.54 each. The example proves that the correlation between the leveraged ETF and the underlying target index can vary dramatically when invested for longer periods than a day.

These levered products make for excellent brokerage and trading software commercials, but rather than getting sucked in to talking baby traders and fast moving graphics, the average day trader or casual investor would be better served by bungee jumping or sky diving to get their adrenaline fix.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in FAS, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Exchange Traded Funds (ETFs). Tags: , , , , , , , .

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