DOUBLE-TROUBLE, TRIPLE THREAT
 

Leveraged ("juiced") ETFs may be the next Wall Street catastrophe.
 
Here is what we feel is the standard chronology for a Wall Street disaster:

1. A good product idea
   
2. That product idea starts to get popular with financial advisors
   
3. Product companies begin mass-producing the product, each trying to "one-up" the others
   
4. Increasingly innovative but more complex varieties of the product become available
   
5. The media starts to poke holes in the now-ubiquitous product
   
6. Product producers and users insist the media and other detractors are wrong (and this gets less press coverage than the stories that show the product in a positive light - that is, a star is born, but the star's flaws are  downplayed) 
   
7. Most of the investing public (including advisors) either don't know about the potential pitfalls of the product, or  ignore those risks
   
8. The risks are eventually realized, and massive losses of money and "face" occur
   
9. Investors and their advisors vow never to be fooled like this again
    

Past examples include 1970s Oil and Gas Partnerships, Junk Bonds in the 1980s, and more recently, CDOs, MBS and other leveraged investments.  Next up: so-called "juiced" ETFs (a reference to the boost athletes get from steroid use).  They appear to us to be today's "gotta have it "product.  
 
We like ETFs, but like many financial creations that came before them, we think they are overused, not sufficiently understood by many who use them, and risk being the poster child for the next embarrassing chapter of the investment advisory business.  How can an investment advisor attempt to avoid being caught in the net this time? In our opinion, it is as simple as this: stick to using ETFs that DO have liquidity and DON'T use leverage to muscle up their returns. We often use ETFs (not the leveraged type) for tactical investing within our portfolios and occasionally as a substitute for a long-term investment in an asset class (we usually use actively-managed mutual funds to participate in our chosen investment themes and styles).
 
When I first heard about leveraged ETFs, I thought I was standing in a Starbucks store.  "I'd like a double-short S&P Midcap Exchange-Traded Fund, please."  While we used them a bit in our early days of ETF work, we stopped using them so as to avoid what we feel may be a "Grande" mishap for our clients.
 
Emerald's Technical Analyst, Michael Kahn, follows ETFs closely and he has researched the leveraged variety for his QuickTakesPro daily newsletter.  He feels the bottom line is this: "these things decay over time whether your market view is right or wrong. Even if the market goes exactly nowhere, leveraged ETFs have a built in decay due to the way their returns are constructed." A common misconception is that these funds will offer a multiple of the annual return of the underlying index, which means that if the S&P 500 returns about 10% a year, then a fund constructed to track 2X the performance of the S&P 500 should return 20%. But that's not the case, a leveraged ETF does not simply exaggerate the annual returns of an index; it is structured to track the daily changes. Where some people get fooled is by expecting that the 2:1 or 3:1 ratio that the ETF delivers on a single day will also be realized over their personal holding period (weeks, months, years).

For example, let's suppose that on Tuesday the market goes up 10%, and on Wednesday it falls 10%. The two day loss for the index is 1%, but the loss for the leveraged fund is 4%. 

Here is the math:

Index: (1 + 10%) x (1 - 10%) = 1.1 x 0.9 = 0.99        (1% loss)
2X Fund: (1 + 20%) x (1 - 20%) = 1.2 x 0.8 = 0.96    (4% loss)

In addition, due to the compounding effect of the above, the more volatile the index, the more a fund's longer-term performance will deviate from its index's longer-term performance. As a quick hypothetical example, if you lost 20% in 2007 but gained 20% back in 2008, you would only be back to $96 for every $100 you started with (not $100 as some might expect).  You would need a return of 25% to get back to $100.  For a leveraged ETF, daily changes are increased due to the use of leverage, and it may become difficult to make up for the increased percentage losses.

Still, for very short-term traders, we believe leveraged ETFs can play a useful role, assuming the investor knows how to use them.  In our opinion, this is not like putting a kid behind the wheel of a Honda Civic - its more like strapping them into a Ferrari - it's not for beginners. 
 
This will probably not be the last article you will read on this subject, as industry regulator FINRA is now stepping up its efforts to control this growing "steroid problem" in the investment markets.   According to Tom Lydon of the ETF Trends online newsletter (July 15, 2009), "informational sweeps at providers' offices are under way, in preparation for a "crackdown."  Morningstar has defended FINRA, stating that retail investors are getting burned by the ETFs, and many lack the needed time to monitor the funds. Direxion and ProShares are heavyweight providers of the leveraged ETF and are rising to their defense by sponsoring educational campaigns for brokers and advisors.
 
Stay tuned, stay educated, stay off the juice.
 
The information herein has been obtained from sources believed to be reliable, but Emerald Asset Advisors, LLC ("Emerald") does not warrant its completeness or accuracy. Prices, opinions and estimates reflect Emerald's judgment on the date hereof and are subject to change at any time without notice. Any hypothetical examples do not include transaction or interest costs, which will reduce your returns.  Any statements nonfactual in nature constitute current opinions, which are subject to change and should not be considered investment advice. Projections are not guaranteed and may vary significantly. Further information on the firm and its advisory fees may be obtained from the firm's Form ADV Part II, which is available without charge upon request. 

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