Categories

Investing Observation & Opinion

Tools

  • Economy & Politics
  • Investing
  • Personal Finance
  • Related Posts


    Meet The Guy Who Helped Add $2 Billion To Twitter’s Valuation Yesterday
    Bank Of America’s Legal Woes Are Only Partly To Blame For Its Disappointing Quarter
    Metals Stocks: Gold Wavers, Copper Edges Up After China Data
    The Best Online Tools To Track Your Investments
    How To Profit By Avoiding Common Investment Errors
    Beware Of The Walking Dead In Your Portfolio
    SodaStream Pops 11% On Minority Stake Sale Buzz
    Yahoo Shares A Good Buy As Alibaba Nears IPO: Analysts
    Mrs. Fields Looks Beyond The Mall
    Europe’s Gentle Clampdown On Flash Boys
    Do You See A Bubble?
    Homebuilder Confidence Misses For 4th Month In A Row
    Stocks Move Higher On Encouraging Profit Reports
    Here’s How Box Can Still Go Public In The Midst Of The Brutal Tech Selloff
    Stocks That Go Up Can Keep Going Up


    174 ETFs You Should Never Buy

    My apologies, but I misspoke last week.

    The most dangerous, wealth-destroying investment in the world right now isn’t cash. It’s leveraged exchange-traded funds (ETFs).

    By my count, there are at least 174 of these in existence. And on the surface, these ETFs promise to double or triple the movements of the underlying markets they track.

    I’m here to tell you that they’ll do anything but.

    You see, double- and triple-leveraged ETFs (whether long or short) pack a nasty surprise. It’s almost unbelievable, actually.

    And particularly in this volatile market, theses ETFs are hardwired for losses.

    Here’s what I mean.

    The Nuts And Bolts Of Leveraged ETFs

    Leveraged ETFs have been around only since 2006.

    Given such newness, let’s first make sure we’re all on the same page regarding the general mechanics of how they work.

    A normal ETF is constructed to mirror the movement of an underlying index. If the index rises 5 percent, the ETF that’s tracking it is supposed to rise 5 percent (before expenses). And an inverse ETF simply moves in the opposite direction of the index that it’s tracking. So if the index drops 5 percent, the inverse ETF should rise 5 percent.

    When you apply leverage, however, these movements are magnified. So if the inverse ETF uses three-times leverage and the index falls 5 percent, the ETF should rise 15 percent.

    Sounds simple enough in theory, right?

    Too bad the reality doesn’t measure up. Or, as Yogi Berra used to say, “In theory there is no difference between theory and practice. But in practice, there is.”

    Leverage? What Leverage?

    Consider this: From January to May 15, 2009, the Russell 1000 Financial Services Index fell by 5.9 percent.

    So a long ETF using three-times leverage should have dropped by 17.7 percent (-5.9 x 3 = -17.7 percent). Instead, it plummeted by 65.6 percent.

    And an inverse ETF using three-times leverage should have been up 17.7 percent. But it sank by 83.4 percent.

    Talk about not getting what you paid for.

    Pick any other period, and I promise it will yield similarly confounding results. And the worst offenders will always be the ETFs using three-times leverage.

    The question is: Why?

    Two Fatal Flaws of Leveraged ETFs

    Just so we’re clear, I don’t detest all ETFs.

    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.

    But when it comes to leveraged ETFs, those benefits are completely nullified by two fatal flaws.

    Fatal Flaw No. 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 will 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.

    But this distinction isn’t being communicated clearly to investors. As a result, the U.S. Securities and Exchange Commission actually felt the need to issue its own warning about the confusion surrounding leveraged ETFs.

    Fatal Flaw No. 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.

    But when it comes to leveraged ETFs, compounding often works against us.

    For example, consider what would happen if a regular ETF drops by 10 percent one day, then rises by 10 percent the next. (And for simplicity’s sake, let’s assume the starting value of the index it tracks is 100.)

    • Day 1: The ETF would be down 10 percent to $90.
    • Day 2: It would rise by 10 percent to reach an ending value of $99.

    Total Return: -1 percent

    Now let’s take a look at what happens with an ETF that seeks double the return of the index (i.e., uses two-times leverage). Again, we’ll assume a starting value of $100.

    • Day 1: The ETF would be down 20 percent to $80.
    • Day 2: It would rise by 20 percent to reach an ending value of $96.

    Total Return: -4 percent (when it should actually be down only 2 percent)

    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.

    Bottom line: 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.

    Ahead of the tape,

    — Louis Basenese

    Louis Basenese Co-Founder, Chief Investment Strategist for Wall Street Daily. A former Wall Street consultant and analyst, Louis helped direct over $1 billion in institutional capital before founding Wall Street Daily where he serves as Chief Investment Strategist. In addition to being an expert on technology and small-cap stocks, Louis is also well versed in special situations, including Mergers & Acquisitions and spinoffs.

    | All posts from Louis Basenese

    Discuss this Story:

    Comment Policy: We encourage open discussion. Comments including racist statements, profanity, name calling or spam will be removed at our discretion. We use filters for spam protection. If your comment does not appear it is likely because it violates the policy.

    Nestle Reports Slow First Quarter
    China Gold Demand ‘On The Rise’
    Don’t Just Sit On Your Investments, Do Something
    Should Google Know Your Deepest Darkest Secrets?
    How Companies Are Using Wearables In The Workplace
    Is This Tiny Gadget The Future Of Smoking?
    Commodity-Backed Currencies? China Buys Huge Copper Mine; Russia Onshores Largest Gold Miner
    BofAML Warns VIX Complacency Suggest Stocks Fall Further
    Futures Tread Water As Geopolitical Fears Added To Momentum Collapse Concerns
    “Shadows Of March 2000″ – Goldman On The Great Momo Crash Of 2014
    Weekly Sentiment Report: Horrific? Hardly!
    Beta Earthquake
    Gold Jumps To 3-Week Highs, EUR Fades As Tensions Rise In Ukraine
    CME Sued For Giving “High-Frequency Traders Peek At Market” Since 2007
    HFT Purge Begins: SEC Prepares To “Remove” Some High Frequency Trading Firms
    GE Capital Seen Ripe For More Slimming After Credit Card IPO
    Ukraine Tensions Land Fresh Blow On Struggling Stocks
    China Targets Trust Firms In Shadow-bank Crackdown
    Citigroup Cuts 200 To 300 Jobs
    Stocks Face Earnings Blues After Tech Slide
    Europe’s Top Banks Cut 80,000 More Staff In Post-Crisis Overhaul
    Check Out Who’s Investing In Bitcoin Now
    There Is No Biotech Bubble; Here’s The Real Story
    Why You Need To Read Michael Lewis’ New Exposé
    Social Media IPOs 2014: Watch For These Companies To Hit The Market
    As Promised, JPMorgan Delivered An Ugly Set Of Trading Results
    The Hedge Fund That Thinks It Can Succeed Where A Criminal Investigation Stalled
    Blythe Masters Under Investigation By Federal Prosecutors
    Carl Icahn Warns: “Easy To Fake Earnings” Thanks To Fed; “Major Correction Coming”
    The HFT Blowback Continues: Fidelity Creates New Trading Venue
    Read more from Investing...

    Liberty Investor Digest

    Get today's most important
    financial headlines all in
    one place by email!



    Sources


    close[X]

    Sign Up For Liberty Investor Digest™!

    Get Liberty Investor Digest FREE By Email!

    Input your name and email address in the fields below and get today's most important financial headlines sent straight to you inbox!

    Privacy PolicyYou can opt-out at any time. We protect your information like a mother hen. We will not sell or rent your email address to anyone for any reason.