Due to market demand, over the past few years we have begun to see another increase in investors' use of leverage. Just ten years ago all the rage was using leverage to buy more home than one could really afford. Before that, it was the increased use of credit cards and way back in the late 1920's it was trading stocks on margin. The use of leverage has time and again blown up in the faces of those who use it at an abusive level.
So today I would like to point out some of the dangers of Leveraged ETFs or better known as 3X ETFs. But first, let's talk about why it's hard to see the danger in these investments. I believe the most glaring reason is because we have been told that ETFs, or any group of investments bundled together in order to provide diversity, is safer than buying individual stocks or investments. And that is completely true, but what makes the leveraged ETFs dangerous is the leverage itself.
The first item to consider is what it costs the ETF to gain 3X leverage. That price is often referred to as deterioration risk. The deterioration of invest-able capital is due to the price the ETF must pay other financial institutions to buy and sell investment instruments in order to gain the 3X price movement of the underlying ETF asset. If the ETF is invested in the oil industry for example, the industry itself will have a limited number of financial instruments to invest in, and often times those instruments will have very little liquidity. The lack of supply and lack of demand for the investment therefore pushes the price of the investment higher for the ETF to purchase. In turn, and over time, that increased cost will deteriorate part of the capital being used to invest.
Daily Trading Only
The next issue is the use of leverage and how it makes returns very unpredictable, especially over long periods of time. Direxion Investments is one company who offers leveraged ETFs. On their website, as well as in the profile summary of each of their leveraged ETFs, you can find a warning to investors which reads:
"These leveraged ETFs seek a return that is +300% or -300% of the return of their benchmark index for a single day. The funds should not be expected to provide three times or negative three times the return of the benchmark’s cumulative return for periods greater than a day."
These investments are being sold essentially to day traders who want to bet on an index or industry moving higher or lower, but for just one day. But due to the leverage these investments are using, someone buying shares even just for a day can get hammered.
For example Direxion Daily Jr Gold Miners Bull 3x ETF (JNUG) was down 19.35% yesterday. Perhaps that was just one bad day? Nope, over the past three months, JNUG is down 83.95%.
You may be thinking, well that's just one ETF which is bullish on gold and gold miners during a time when the price of gold has been flat or falling. That’s a great point!
But, even the Direxion Daily Gold Miners Bear 3x ETF (DUST) is down 38.99% over the past month and while investors who own Direxion Daily Jr Gold Miners Bear 3X ETF (JDST) made 20.64% yesterday, the ETF is still off by more than 40% over the past month and 76.84% over the past year.
So regardless of whether you were correct in predicting a few months ago that gold would be hurt by falling oil prices, if you had placed your money in either of the 3X leveraged gold Bear or Bull ETFs you would have lost money over the past month because of the unpredictable nature of the leveraged product over more than a one day time frame.
Leverage Exponentially Increases Gains and Loses
Another great example of the potential danger from the leveraged ETFs actually comes from the best performing year-to-date 3X ETF, the Direxion Daily Real Estate Bull 3X ETF (DRN). DRN is up 100.25% thus far in 2014. DRN is clearly killing the S&P 500's 11.8% year-to-date gain, but I see two big issues here.
First, in order to get that sort of performance, investors have taken quite the roller-coaster ride. DRN was at $67.20 on September 5th, but was down to $52.73 on September 25th. That’s a 21.53% fall in just 15 trading days. When we compare that fall to the market as a whole, on September 5th the S&P 500 was at 2,007.71 and fell to 1,965.99 on the 25th. So for argument's sake, we could say the market was also down during that time frame, but it only fell by 2.07%, a 19.66% difference.
Anyone holding DRN is likely going to have a few sleepless nights and certainly some nervous trading days.
Lastly, my biggest issue with these products and the one question investors should consider asking, is that if DRN can outperform the market by nearly 90% over the past 11 months and provide investors with slightly more than a 100% return during that time frame, the question must be raised, "Why can't the opposite happen?" Even if an investor is in and out of the stock every other day, massive losses can and will eventually occur with these types of investments.
So, ask yourself, "Can I afford to take a 100% loss?"
Even though ETFs provide diversity and reduce investors' risk, not all ETFs are created equal. Using leverage is very dangerous and only those investors who fully understand the risks and can sustain massive losses should be using it to increase gains.
Lastly, what's so bad about just a standard un-leveraged ETF anyways? If you were to ask most investors, they would gladly take a low risk 7% return annually over an extremely high risk roller-coaster ride any day. Just remember next time you see massive year-to-date returns from a leveraged ETF, the tortoise always beat the hare.
Check out my post next week,
INO.com Contributor - ETFs
Disclosure: This contributor has no positions in any stocks mentioned in this article. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.