Smart Investing Daily – The Truth About ‘Leveraged ETFs’

Jared Levy, Editor, Smart Investing Daily
Friday, 21 January 2011

funds Back in early October, after a visit to the Texas State Fair, I wrote about inflation and the global food “problem” and how you can take advantage. Every stock I mentioned in the report has seen substantial runs since then.

Keeping all of our greed under control, Sara recently detailed why commodities and the agri-stocks climbing with them needed a nap, and why maybe it was time to take profits.

What does this have to do with leveraged ETFs, you might be asking? Well, I thought I would use food as an intro, because it offers a great analogy for my views on leveraged ETFs (OK, and maybe I wanted to remind you how Smart Investing Daily keeps you ahead of the curve).

Both gluttony and greed are two of the “seven deadly sins,” but with food especially, some of us tend to eat more than we need to and with that, the very thing that brings us life and energy can also cause illness disease and death (in severe cases). I bring up these morbid reminders, not to scare you out of satisfying your hunger for food, but to remind (or inform) you that some investment vehicles (leveraged ETFs) might be just as unhealthy and perhaps even dangerous for your portfolio, forcing you to “eat” fees and expose yourself to risks you may not even be aware of. Too much of something is not always a good thing.

Leverage

According to Wikipedia, “leverage is a general term for any technique to multiply gains and losses.” You can attain leverage by borrowing money, purchasing fixed assets or using derivatives like options or futures. Basically, you can think of it as using a lesser amount of money to buy (or sell) a larger amount of something like a stock or other investments.

Leverage can be a good thing of course; many of us use our credit as a source of leverage, so we can purchase high-ticket items now that we feel may rise in value (take your home, for instance).

You also use leverage when you purchase a stock on margin from your broker.

There is no such thing as a free lunch; for that leverage we have to pay fees, costs, interest, etc. (These are called carrying costs.) Hopefully the amount that we are paying in carrying costs is less than the appreciation or income we are receiving from the asset we have leveraged.

If we take on too much leverage and the asset doesn’t appreciate or even worse, decreases in value, you will still have to digest tons of carrying costs. You will have to “consume” those costs with nothing to show for it, except for maybe heartburn, caused now by stress.

Greed and Leveraged ETFs

Leveraged ETFs like Direxion Daily Financial Bull 3X Shares (FAS:NYSE), Direxion Daily Financial Bear 3X Shares (FAZ:NYSE), Direxion Daily Gold Miners Bear (DUST:NYSE), Direxion Daily Real Estate Bull 3X Shares (DRN:NYSE) and many others have become extremely popular; they enable you to maybe make $2 or $3, even when a stock or index were to only move $1 (of course you would lose $2 or $3 for a $1 move in the opposite direction). There are even ETFs that move opposite to the way the underlying stock or index is moving. So if the stock is UP $1, the ETF would be DOWN $1 or $2 or $3, depending on what type of leverage they are using (talk about confusing).

For that leverage, ETFs charge you a fee — more on that in a second.

Leveraged ETFs are not evil; if you know exactly what you are doing, how they work and how to invest in them, you can profit. The reality though is that the “leveraged” part appeals to the greedy side of most retail investors, who have minimal knowledge of the way they work and end up losing money because they didn’t do their homework.

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)

The Mechanics of Leveraged ETFs

Leveraged ETFs were specifically created for professionals and short-term traders and most have nuances you must understand before investing even $1 into them.

Here is an example, using the Direxion Daily Financial Bull 3X Shares (FAS:NYSE), which is a very popular leveraged ETF.

The FAS is purported to return 3X (300%) the movement of the financial sector index on a daily basis, which it can do so, but not all the time and not if held for a duration longer than a day (yes, a day).

Here are some nuances of the FAS:

FAS bases its return off of the Russell 1000 financial index (RIFIN.X) (make sure you know what the ETF you are trading is based off of, it may surprise you).
FAS charges about 1% per year in basic expenses; there are also transaction costs and tax implications you should discuss with your financial and tax advisor.
Most leveraged ETFs like FAS use derivatives and complex financial instruments like total return swaps to gain their leverage, which are created by and traded with firms like Goldman Sachs, UBS, Deutsche Bank and others, they (you) pay those firms a fee to provide this.
Returns of the ETF over time may NOT be even close to the returns of the index it’s tracking!

Get this — In 2009, the Russell 1000 financial index was up about 30%. You would think that the FAS should be up three times that (maybe 90%) in the same time frame. Wrong! The FAS actually lost 34%, so if you were completely correct in your trade and held the FAS for a year, you lost money!

The Devil Is in Daily Rebalancing

Most leveraged ETFs get their leverage only for the day and then at the end of the day, that leverage resets, which can hurt you in the long term. This is the biggest profit siphon when investing in a leveraged ETF.

*Check out what happens if the Russell 1000 index moves up 3% today and drops 3% tomorrow and you are long the FAS.

If you bought FAS today at $30, it would move up about $2.70 (9%). At the end of today, the ETF would actually take those profits and invest them the next day starting fresh (this is rebalancing).

So tomorrow, you now have $32.70 invested at three times leverage, so if the Russell index then drops 3%, the FAS would drop 9% (of $32.70) and you would now lose $2.95, leaving you with a net loss of $0.25, even though the underlying index is actually flat.

Scared, Confused or Both?

In closing, don’t get sucked in with the lure of leverage, it may just leave you with a really bad case of high carrying costs and losses in your account. Know what is in the ETF and how it works before you trade. If you do trade them, you should only be trading very short term, less than three days, preferably intraday.

P.S. Join Smart Investing Daily’s Sara Nunnally as she sits down for a one-on-one discussion with Jordan Goodman of The Money Answers Show. Sara will discuss the new book, Barbarians of Wealth, she co-authored with Taipan’s Executive Publisher Sandy Franks… and how you can protect yourself against today’s greedy, self-serving barbarians in Washington and on Wall Street.

The Money Answers Show with Jordan Goodman airs on Monday, Jan. 24th at 12 pm PT. You can learn more about Sara’s interview here.

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