So writes Louis Basenese (www.wallstreetdaily.com) in edited excerpts from his original article* entitled 174 ETFs You Should NEVER Buy.
[The following article is presented by Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com and www.munKNEE.com and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]
Basenese goes on to say in further edited excerpts:
The Nuts and Bolts of Leveraged ETFs
A normal ETF is constructed to mirror the movement of an underlying index. If the index rises 5%, the ETF that’s tracking it is supposed to rise 5% (before expenses). An inverse ETF simply moves in the opposite direction of the index that it’s tracking so, if the index drops 5%, the inverse ETF should rise 5%. When you apply leverage, however, these movements are magnified so, if the inverse ETF uses three-times leverage – and the index falls 5% – the ETF should rise 15%.[The above] sounds simple enough in theory, right? Too bad the reality doesn’t measure up [as I explain below.]
Leverage? What Leverage?
Consider this: From January to May 15, 2009, the Russell 1000 Financial Services Index fell by 5.9%. [As such,] a long ETF using three-times leverage should have dropped by 17.7% (-5.9 x 3 = -17.7%). Instead, it plummeted by 65.6%. An inverse ETF using three-times leverage should have been up 17.7%. Instead, it sank by 83.4%. Talk about NOT getting what you paid for.
Pick any other period, and I promise leveraged ETFs will yield similarly confounding results. The worst offenders will always be the ETFs using three-times leverage. The question is, why?
2 Fatal Flaws of Leveraged ETFs
Just so we’re clear, I don’t detest all exchange-traded funds. Regular ETFs provide a low-cost way to achieve instant diversification and access markets that aren’t readily available and, unlike traditional mutual funds, they provide intraday liquidity. When it comes to leveraged ETFs, however, those benefits are completely nullified by two fatal flaws [as outlined below].
~Fatal Flaw #1: Daily Rebalancing
Leveraged ETFs don’t actually buy individual stocks. Instead, they invest in derivatives and these derivatives require daily rebalancing in order to match the rise or fall in the index. Otherwise, the leverage ratio for the ETF would be off-kilter. That means leveraged ETFs can only be counted on to perform (as promised) for a single day. In other words, they’re for day traders only – not investors. [Unfortunately,] this distinction isn’t being communicated clearly to investors. As a result, the SEC actually felt the need to issue its own warning about the confusion surrounding leveraged ETFs.
~Fatal Flaw #2: The “Dark Magic” of Compounding
For years, we’ve been wooed by the magic of compounding returns. If you’re 18 years old and invest $2,000 per year for three years (and not a penny more after that), they say you’ll end up a millionaire if you simply leave it invested and let compounding work its magic.
When it comes to leveraged ETFs, [however,] compounding often works against us. For example, consider what would happen if [the associated index were to] drop by 10% one day, then rises by 10% the next (and, for simplicity’s sake, let’s assume the starting value of the index it tracks is 100).
a) A regular ETF performance would be:
- Day 1: The ETF would be down 10% to $90.
- Day 2: It would rise by 10% to reach an ending value of $99.
- Total Return: -1%
- Day 1: The ETF would be down 20% to $80.
- Day 2: It would rise by 20% to reach an ending value of $96.
- Total Return: -4% (when it should actually be down only 2%)
If we ratchet up the leverage to three-times and extend the holding period, it magnifies the negative impact of compounding. Toss in some market volatility, which we’re experiencing now, and this tracking error gets even worse.
Beneath a simple exterior – and the allure of a novel hedging strategy – there are considerable complexities and risks associated with leveraged ETFs.
Unless you’re a day trader, with an uncanny ability to predict every jot and tittle of the market, avoid leveraged ETFs like the plague. Heck, even if you could pull off such a feat, the transaction costs would eat your portfolio alive, so the best bet is to simply avoid leveraged ETFs altogether.
[Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.]
*http://www.wallstreetdaily.com/2013/06/26/leveraged-etfs/ (© 2013 Wall Street Daily, LLC All Rights Reserved; If you enjoy reading our no-nonsense, unbiased research at Wall Street Daily, feel free to share it with your family, friends and colleagues. Simply send them this link, so they can sign up for the TRUTH… for free, of course. Have a question or want us to expose the truth? CONTACT US)
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