Leveraged ETFs: Is The Risk Worth The Potential Reward?

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June 28, 2013 3:06pm NYSE:FAS NYSE:FAZ

leverage-decayRudy Martin: A master chef with the right kitchen tools—including a fine set of cutlery—can create a memorable dining experience.

But the same knife that produces a photo-worthy gourmet masterpiece can produce a messy result in the hands of a novice or distracted cook.

The same can be said for some investment instruments. Even if you’ve achieved a level of mastery or, at least, comfort with stocks, you might shy away from other assets because you know the end result can turn out a lot different than the recipe suggests!

When it comes to certain classes of Exchange-Traded Products, you can give them to an educated and experienced professional, and they can easily enhance their financial returns while minimizing risks.

But for those who don’t take the steps to get comfortable with how to operate these powerful tools before they use them, the end result is usually an investment disaster.

Today let’s look at a special class of ETFs that, with just a small bit of knowledge, can help turn you into an iron chef of the investing variety!

Is the Risk Worth the Potential Reward?

To their credit, fund firms that offer open-end mutual funds and ETFs leveraged in absolute (amplifying an upward move) or inverse (that is, profiting from a down move) terms tend to emphasize that their offerings work best over short holding periods.

When you do your research on these funds, you’ll see words and phrases such as “daily” and “for a single day” permeating their literature. That is intentional on their part … they are clearly telling you that these are trading vehicles and that longer-term investors should probably look elsewhere.

If you are able to be near your computer when you buy a leveraged ETF, and can take quick action to grab gains when you see them, you are likely to find that results over short time periods tend to behave fairly consistently with the stated intentions.

Longer term, however, even small deviations over time can compound to seriously distort results.

How Leveraged, Inverse ETFs Work … and Work Together

For example, the ProShares Ultra Financials ETF (NYSEARCA:UYG) seeks daily results that correspond to twice the daily performance of the Dow Jones U.S. Financials Index. (“Ultra” is usually code for “double” — you may also see other funds use “2X” to mean the same thing.)

So if financials go up by $1, the UYG seeks to return $2 for that move.

There are also leveraged inverse ETFs. Think of cars on a highway – they’re going different directions, but the cars work the same on both sides of the median.

If the UYG is traveling north, then the ProShares UltraShort Financials ETF (NYSEARCA:SKF) is heading south. The SKF aims to replicate, before fees and expenses, twice the inverse daily performance of the Dow Jones U.S. Financials Index.

As you can see, one is a bet on the Financials Index going up, and the other bets on it going down. Using these leveraged funds, you’ll likely see a return more-quickly than investors in a non-leveraged fund … and that’s why it’s important to pick the right direction from the outset.

You can see a fast return, all right — it just might not be the one you wanted!

How These Financial ETFs Were Set to Perform …

Stock-picking (and ETF-picking) is all about getting the direction right. With leveraged and inverse ETFs, you have to be pretty spot-on in your directional call … and be ready to grab gains or cut losses when the move takes place.

Now, you don’t need to station yourself at your computer when you buy one of these instruments. But you should be aware that these cars are powered by jet fuel, so you shouldn’t take your eye off of them for long periods of time.

Let’s look a little closer at how the financials are performing overall, and how these particular funds have fared to date.

Over the five-year period ended May 31 of this year, the Dow Jones U.S. Financials Index retreated at an annualized rate of 0.31%.

Both UYG and SKF have recently achieved success over periods as long as several months. But as ProShares repeatedly implies in its literature, these funds are not appropriate for longer-term investing. (Forgive my repetition here — I cannot stress this enough.)

A 2X-inverse leveraged fund tracking the financial index, theoretically, should have advanced at an annual pace of about 0.62% per year (less fees and expenses). So, then, a 2X-leveraged fund should have retreated at roughly 0.62% annually before fees and expenses.

… And How They Actually Performed

And now for the actual five-year results …

Long-side-leveraged UYG saw an annualized loss of 19.58%. And the ultra-short-geared SKF realized an ugly 44.69% annualized setback for the past five years.

That’s right, both the long-side-leveraged and the short-leveraged sank drastically over the long term.

Wasn’t one of them supposed to go up when the other retreated?

That isn’t an indictment of the management capability of ProShares, which meticulously stresses that these ETFs are intended to adhere to their mandates only for daily time horizons.

However …

It is a crucial lesson that long-side or short-side leveraged mutual funds and ETFs are not appropriate as long-term investments!

With Leverage, Less is More …
Both in Time and in Money Spent!

I’m a fan of leverage … in the right situations. In fact, my Global Trend Trader subscribers are in two leveraged plays right now.

In the recent absence of any positive news on economic growth in China, I recently recommended a position in a short China fund — a deliberate move to profit from erosion in one the world’s biggest economies. (Full disclosure: I recommended grabbing gains yesterday.)

Now, unlike much of Wall Street, I’m not bearish on China overall. As we discussed last week, China has two economies and right now it makes sense to be bullish on one and bearish on the other.

As the U.S. financial ETFs have shown us, even diversified ETFs can produce unanticipated results. No investment outcome is guaranteed, whether you’re using leverage or not — leverage simply serves to enhance your winnings … or your losses.

Another reason to pay close attention to these kinds of ETFs is because many of them are actively managed.

The bulk of ETFs are passively managed — that is, the stocks and those stocks’ allocations are changed infrequently and, therefore, their fees are kept in check. But actively managed funds can see a relative high turnover of the investments contained within them … and that also tends to result in higher fees for the individual investor.

Bottom line: Leverage isn’t for everyone, and it’s perfectly OK to stay away from it unless or until you are absolutely comfortable with the potential risks-vs.-rewards they present.

I am a firm believer that ETFs should be part of every investor’s arsenal. If investing in stocks is like owning a good set of knives, then ETFs are like having some really good appliances that you can plug in, turn on and basically let them do some of the work for you.

ETFs with leverage, then, might be more like that fancy food processor that you really wanted but might not fully know how to use yet. It doesn’t mean that you won’t … but it does mean that maybe you’ll want to use the instructions before attempting a more-sophisticated dish!

Rudy MartinThis article is brought to you courtesy of Rudy Martin.

Uncommon Wisdom Daily is a free daily investment newsletter published by Weiss Research, Inc. This publication does not provide individual, customized investment or trading advice. All information is based upon data whose accuracy is deemed reliable, but not guaranteed. Performance returns cited are derived from our best estimates, but hypothetical as we do not track actual prices of customer purchases and sales. We cannot guarantee the accuracy of third party advertisements or sponsors, and these ads do not necessarily express the viewpoints of Uncommon Wisdom Daily or its editors.

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