Me On Leveraged WTFs- I Mean, ETFs…

Every once in a while, I get contacted to answer questions and/or provide quotes for articles, news programs, etc. (Nothing will ever be as neat as the feature in Grazia though.) The latest was an inquiry from a very nice fellow named Chris Taylor, who is the money guy for Reuters. Here’s the article, and we’ll get to the larger context afterwards:

Doubling Down: Leveraged ETFs offer promise – and danger

Doubling Down: Leveraged ETFs offer promise – and danger

In a volatile market, boring investments can be pretty darn sexy. That is why investors have plowed more than $4 trillion into exchange-traded funds, according to London-based research firm ETFGI.

Source: www.reuters.com/article/us-money-investing-leveragedetf-idUSKCN1B11JX

Okay, what actually happened was basically this:

Chris: Can I ask you some questions about leveraged ETFs?
Me: Oh hell no.
Chris: Oh sorry to disturb you.
Me: Nono, that’s my reaction to leveraged ETF, not to you. I HAVE THOUGHTS- fire away.

Here’s the overall Q&A in case you’re curious:

Q: To what do you attribute the rise of these ‘leveraged’ ETFs, offering 2x or 3x returns?
A: I think once ETFs became a thing this was a logical next step. The purpose of the basic ETF is to mimic participation in a mutual fund, either passive or active, with less logistical overhead. (In other words, i can go buy an ETF easier than I can set up an account with Fidelity, and so on.) One follow-on effect of this is that it’s now possible for smaller investors to bet on various indices and funds by trading their ETFs. (Larger investors generally do this directly rather than going through the ETFs.) Similarly, leveraged ETFs mimic behavior that already exists among large investors (though more hedge funds and such rather than traditional asset managers) but make it feasible for smaller investors to essentially do the same thing (and, in at least some cases, at lower expense). If I had to speculate, I would say that the increased sophistication of ETFs has followed changes in the strategies and behaviors of large investors.

I think a persistent low interest rate environment has also encouraged this, since investors are looking for more and more creative ways to eke out nominal returns.

Q: Can or should they be a part of individual portfolios, or are they more for day traders?
A: Leveraged ETFs are almost exclusively for investors looking to trade frequently and “time the market,” etc. One reason for this is almost purely mathematical- many of the leveraged ETF are constructed to magnify short-term (eg. daily) ups and downs but don’t necessarily magnify longer term returns in the same way. (To think about this, consider that a 1% increase followed by a 1% decrease looks approximately the same as a 2% increase followed by a 2% decrease, but there are important differences as illustrated below. Put simply, percentage returns are not additive, so things get weird if it’s the percentage returns that are being magnified by the ETF.) If I was looking for a long-term investment, I don’t see the appeal of a product with higher daily volatility unless it also confers at least proportional higher average long-term returns (and even then…).

Another reason that leveraged ETFs are unattractive from a long-term perspective is that they generally have higher fees than more traditional ETFs and similar products. For those specifically looking to, um, leverage the leveraged ETFs, this is not so bad since they are usually cheaper than explicitly borrowing and such to execute what the ETF is doing for you, but the fees only make sense if you are specifically looking for the behavior of the particular product.

I guess I’m speaking here to how they *should* work, not how they actually work, so it’s entirely possible that misguided long-term investors do hold them. Oops.

Q: Most people are not great at investing — mistiming market, trading on emotion, trading too frequently – so do these products appeal to our worst instincts?
A: *does quick Google search* Yes? I would add that most people are not great at investing in a stock-picking sense even when they are trading less frequently. (This isn’t a statement on people so much as it is one on market efficiency.) I think leveraged ETFs appeal to the same characteristics, but the magnification of returns could make it so a (risk loving) person who wouldn’t bother trading normal ETFs and such could be tempted to play around with the leveraged versions. A good analogue of this situation is stocks versus stock options- the (figurative, not literal borrowing) leverage might make trading options appealing for some individuals who wouldn’t be interested in trading the underlying stocks.

Q: If investors are determined to buy them, any strategies for making sure they don’t get carried away and assume too much risk?
A: Are you making trading our own assets your full time job? No? Then stay away. And even then… πŸ™‚ I guess you said determined to buy, so…don’t be fooled by perceived diversification. You can have a leveraged ETF that tracks the S&P500, fr example, and it looks like you’re diversified over 500 stocks, but I would argue that this isn’t enough when leverage is involved. It’s incredibly important to diversify across the leveraged ETFs and other investments, or, perhaps even better, to specifically hedge the leveraged ETF position, though this mitigates the effects of the leverage to some degree. (If you don’t believe me, consider that the companies that sell you the leveraged ETFs specifically hedge their exposure to you!).

Or, tl;dr:

Update: Finance friend makes one of my points more clearly than I did:

*works through arithmetic* So a 25% increase would be turned into a 50% increase with a 2x leveraged fund, hence 100 to 150, then a 20% decrease would be turned into a 40% decrease, hence 150 to 90, i.e. putting you below where you started even though the underlying index went back to its original point. Similarly, a 25% decrease would be turned into a 50% decrease, so 100 to 50, then a 33% increase would be turned into a 66% increase, so 50 to 83. In both cases, the value of the underlying index went back to its original point but the value of the leveraged ETF did not. (In general, holding a leveraged ETF erodes returns when markets are volatile and amplifies them when markets are steadily increasing or decreasing.) This could be different, however, with leveraged ETfs that are in some way tracking the underlying price rather than the return, so read the prospectus! Or just stay away. πŸ™‚