Leveraged ETF risk

[MichaelB]

If one has a long term investment horizon and judges current equity (S&P 500) prices to have considerably greater upside potential than downside risk over a 5-7 year period, is it not better to use leveraged long products like Ultra Proshares or Rydex funds over index ETFs? Is there a real downside other than index loss?

I understand there will be a tracking error due to index volatility and expense drag vs the index. What is not clear is if there is a realistic potential for loss due to problems with underlying assets and strategy execution, such as a derivatives loss. Neither Rydex nor Proshares seem to have suffered during the current financial upheaval, which is reassuring, and the volumes traded for products like S&P 500 are quite high.

Just wondering if this isn't an opportunity as long as one is willing to take the equity risk.

Michael

 

[clifp]

I think Buffett's comment that leverage is the only way for smart men to go broke is worth repeating.

My question is why wouldn't you be better off getting a low cost ETF and using a margin or HELCO?

 

[soupcxan]

If you are a REAL MAN, then you will do as I have suggested in other threads and buy the 2x leverage ETFs on margin, thus giving you 400% leverage.

 

[Culture]

OK, this raises a question that I have always had. Lets suppose that I have $100,000 that I absolutely will not need for 20 years and can afford to loose 100%. What is the disadvantage to investing in a long fund? I understand that the volatility is greater, but so is the return. Will the high expenses kill the increases performance? What am I missing?

 

[youbet]

I have $100,000 that I absolutely will not need for 20 years and can afford to loose 100%............ what am I missing?

If you're not RE'd, you should be. If you're RE'd you should be spending more and enjoying life.

 

[Gardnr]

Can somebody enlighten me on this? If the underlying index for one of these 2X leveraged ETFs goes down more than 50%, what does the ETF do? Theoretically it would go down 100%. Would it go to zero? What about a more than 50% drop in the index? It can't go negative, now can it?

I'm just trying to figure out how these things would work in the extreme on the downside. I realize how it would work if I margined up myself but not how these ETFs would react.

With that said, the UltraS&P500 ProShares ETF is down 70% (and there's a $5 discount from NAV presently) from the mkt high while the index is down about 43% so the ETF should be down 86%. That's a pretty big difference it seems to me. I suppose that's good for any poor soul that may have held it all the way down!

 

[MichaelB]

I think Buffett's comment that leverage is the only way for smart men to go broke is worth repeating.

My question is why wouldn't you be better off getting a low cost ETF and using a margin or HELCO?

Still leverage - just at my higher cost of leverage. No chance using a HELOC - my house is gonna stay that way (mine).

OK, this raises a question that I have always had. Lets suppose that I have $100,000 that I absolutely will not need for 20 years and can afford to loose 100%. What is the disadvantage to investing in a long fund? I understand that the volatility is greater, but so is the return. Will the high expenses kill the increases performance? What am I missing?

Can somebody enlighten me on this? If the underlying index for one of these 2X leveraged ETFs goes down more than 50%, what does the ETF do? Theoretically it would go down 100%. Would it go to zero? What about a more than 50% drop in the index? It can't go negative, now can it?

I'm just trying to figure out how these things would work in the extreme on the downside. I realize how it would work if I margined up myself but not how these ETFs would react.

With that said, the UltraS&P500 ProShares ETF is down 70% (and there's a $5 discount from NAV presently) from the mkt high while the index is down about 43% so the ETF should be down 86%. That's a pretty big difference it seems to me. I suppose that's good for any poor soul that may have held it all the way down!

Oct 9 '07 thru Oct 22 '08. S&P lost 43% and the 2X leveraged ETF lost 72%. The difference is probably tracking error due to daily settlement. The same loss would be expected upwards as well.

I'm not sure how dividends figure here yet. At 5% or so yields, they would have a significant long term effect. More analysis called for here.

 

[ERD50]

Another way to leverage is to buy deep in-the-money options on an ETF like SPY.

example: SEPT 2009, $50 Strike, selling for $43 (41.90/43.00 bid/ask). SPY @ $91.71.

So the $50 strike plus the $43 you pay, means you need SPY @ $93 to break even. Every dollar > $93 is a dollar profit for you. Yet, you only have $43 invested, so it is a bit more than 2:1 margin. Of course, that works against you the same ratio below $93, and at SPY = $50, (heaven forbid!) you lost the whole wad.

So, if you want to take the 'risk' (and I must say, it would be tempting if I was in the accumulation phase with time on my side), it is simply a matter of comparing costs. But these SPY options trade very openly, I bet they are pretty competitive. The option will also include the 'cost' of holding that money risk-free - the seller has to recover at least that much, plus the speculation component.

Funny thing is, you can't do margin in an IRA, but I'm pretty sure that if you were approved for buying options, you could do this, and it is actually worse (or better, depending on your view) than 50% margin.

Good luck, and be careful out there! IF you have success, be 100x more careful the next time, or you will give it all (and more) right back to Mr Market!

-ERD50

 

[Canadian Grunt]

I think Buffett's comment that leverage is the only way for smart men to go broke is worth repeating.

My question is why wouldn't you be better off getting a low cost ETF and using a margin or HELCO?

If you know the history of Warren Buffet, he used investor’s money to start his investment career. Although not directly leverage as they were partners, he was still responsible for their investments. He used their money as a form of leverage to increase his purchase power and return through his fees.

I think his comment applies to esoteric forms of leverage, options, and margins, where the investor cannot take the long term buy and hold approach due to the nature of these products.

Using an interest only line of credit or an ETF with double hedge characteristics for a long term buy and hold strategy is a viable approach as long as it is done in moderation and the investor has the means to service the product without liquidating due to a shortage of cash flow. In effect you are turning your household income into a business investment. The key factor is research; is the product and the investment suited to a long term buy and hold strategy? And, is the investment expected to gain over the long term.

I think there are some solid investments out there that fit into the category of excellent long term investments and may be suitable for a leveraged approach with the appropriate research.

I would strongly recommend reading “The Warren Buffet Way”; it was endorsed by Warren Buffet and gives a detailed account of how an individual investor can use Warren Buffets investment strategy, and the differences between his approach and Benjamin Graham's approach.

Graham's approach to investing is very hard to use in the modern market as his metrics don't take into account many of the factors that drive the market in 2008.

 

[MichaelB]

Thanks for the replies. I'm going to look a bit deeper but do nothing for now. I'm less concerned about leverage than I am about derivatives, and the dust still needs to settle. I'm not sure we have seen the worst of financial trouble.

Michael

 

[Olav23]

The leveraged ETFs do not give you 2x the yearly return, they give you 2x the DAILY return. Read up on something called the "constant leverage trap". Here is a good explanation:

The Case Against Leveraged ETFs - Seeking Alpha

 

[LA Times reporter]

LA Times reporter wants to interview you

I'm a Wall Street reporter at the L.A. Times who would like to speak with anyone who invests in leveraged or inverse ETFs for a story about their surging popularity. If you've invested in a leveraged or inverse ETF of any kind, either now or in the past, I would like to chat with you about your general thoughts, investment strategy, etc. Please drop me a line at walter.hamilton@latimes.com and let me know when you might have a few minutes either later today or on Monday. Thanks very much.

 

[W2R]

LA Times Reporter has requested and received permission to post this, and he appears to be genuine and a reporter for the LA Times.

 

[Animorph]

I'll second Olav23. Leveraged and inverse etf's are not long-term investments. The daily movement match does not match the index over longer periods. Morningstar and Fidelity have also published articles about this. In some cases the long-term performance is the opposite of the intended direction, even while daily movements are matched. It's at least partially the old -50% down means you need +100% to recover problem.

 

[LA Times reporter]

Animorph --

Have you invested in leveraged ETFs yourself?

 

[audreyh1]

Reporter - have you been over to the Morningstar discussion forums? There are lots of discussions of leveraged ETFs over there by people using them.

Audrey

 

[LA Times reporter]

Good suggestion, and I'll go there next. Thanks.

 

[Animorph]

I have been tempted by SH, a simple inverse S&P500, but never tried it. Not enough conviction I guess.

 

[MichaelB]

After starting this thread I did some DD and concluded that leveraged ETFs are like rat poison.

1. They have a legitimate purpose – very precise and also very limited.
2. If they stay around when not needed, bad things are likely to happen.
3. If you don’t know exactly how to use them, you’re going to get hurt.
4. Avoiding harmful outcomes is as or more important that achieving the stated goal

The more focused the ETF the greater the tracking error – hence the more limited the application. The ones with broader underlying indexes have many other investment alternatives - such as margin and options.

My conclusion – the leveraged ETF is like toxic waste - it has no place in a retail investor’s portfolio.

 

[haha]

After starting this thread I did some DD and concluded that leveraged ETFs are like rat poison.

My conclusion – the leveraged ETF is like toxic waste - it has no place in a retail investor’s portfolio.

I would definitely agree. My first experience was with AFBIX-a mutual fund that simulates a bear position on high yield debt. I bought this back when spreads were tiny, before we discovered the perils of debt. So my timing was close to perfect. Over time, the bottom fell out of the high yield market. I made some money, but the (harmful)tracking error was huge. And mind you there was no 2x or 3x involved- just a synthetic bear position taken via derivatives. I tried a few others and had more or less the same result, or worse. It is possible to be right on the underlying index, and still get killed with these synthetic products. These things stink not primarily because of leverage, but because of their design and implementation.

I do think that since it is almost impossible to make any money long these products, they may make excellent shorts. If you don't overreach and have any luck at all it should work. I haven't tried it yet, because I want to be damn sure before I lay out any money. They may also be pretty safe to sell options against, if you are sure you have the relationships worked out.

One hazard to true short positions in these ETFs is regulators are getting interested in this area, and if they get around to doing anything it might be hard to predict what they might do, and what effects it might have.

Ha

 

[clifp]

These things stink not primarily because of leverage, but because of their design and implementation.

I do think that since it is almost impossible to make any money long these products, they may make excellent shorts. If you don't overreach and have any luck at all it should work. I haven't tried it yet, because I want to be damn sure before I lay out any money. They may also be pretty safe to sell options against, if you are sure you have the relationships worked out.

One hazard to true short positions in these ETFs is regulators are getting interested in this area, and if they get around to doing anything it might be hard to predict what they might do, and what effects it might have.

Ha

Any idea how practical these things are to short? I would be interested in shorting both the double or triple long and short ETF. A while ago I was trying to figure out how to short US treasury bond, it was one of those positioning, where I was confident of the direction but not at all confident of the timing. I went through the list of government bond ETF, and not a single one was available for shorting via Schwab.

 

[haha]

Any idea how practical these things are to short? I would be interested in shorting both the double or triple long and short ETF. A while ago I was trying to figure out how to short US treasury bond, it was one of those positioning, where I was confident of the direction but not at all confident of the timing. I went through the list of government bond ETF, and not a single one was available for shorting via Schwab.

I abandoned the idea because volume was poor and spreads wide. Also, it could get a lot worse. which makes a short position kind of dicey. I like teh idea, but the details seemed daunting.

Ha

 

[redduck]

Got a question: Are ETFs that deal in futures considered to be leveraged ETFs? I'd like to know since I own such an ETF, "UNG."

 

[haha]

Got a question: Are ETFs that deal in futures considered to be leveraged ETFs? I'd like to know since I own such an ETF, "UNG."

Carefully read the prospectus. I did, and I sold UNG.

Ha

 

[redduck]

Guess I bought the UNG you sold. But, how is it that you bought UNG before you read the prospectus?