Sorting out their ‘Fundamental Flaw’

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By Joseph Cafariello

Thursday, May 29th, 2014

Despite being a tiny part of all investment choices, leveraged exchange-traded funds may have the potential to destroy the entire investment market or so warn some notable investment fund managers.

For one, Larry Fink, CEO of Black Rock Inc. (NYSE: BLK), the largest investment fund company in the world, with over $4.3 trillion under management, warned investors yesterday that leveraged ETFs have a structural problem that could blow up the whole industry one day. Wed never [offer] one, he rejected.

Its not that they are shrouded in mystery or that they use overly complicated algorithms that makes leveraged ETFs so dangerous. On the contrary, they are as transparent and as highly regulated as any other fund out there.

Leveraged ETFs are well regulated, transparent products and there is no credible evidence that they have any harmful effect on the markets or our industry, defends Tucker Hewes, a spokesman for ProShares, one of the largest providers of leveraged ETF products.

Of the $2.5 trillion global ETF market, leveraged ETFs make up only 1.2%, worth a mere $30.3 billion contained within some 270 funds out of thousands of ETFs. But dont let their diminutive market share fool you. Leveraged ETFs pack a powerful punch.

Just what is it about them that makes them so potentially destructive? Why do so many investors consider them useful? Do we really need them in the first place?

The Anatomy of a Leveraged ETF

As explained by ProShares, leveraged or geared ETF products provide magnified (2x, 3x) or inverse (-1x, -2x, -3x) exposure to equities, fixed income, currencies and commodities.

For instance, where the S&P 500 index moves 1%, the Ultra S&P 500 leveraged ETF offered by ProShares (NYSE: SSO) moves 2%, it being a 2x geared fund like changing gears on your bicycle, where one complete rotation of your pedals gives you twice the rotation of your wheel.

On the surface, leveraging your investment with a 2x or 3x ETF isnt any worse than buying a standard ETF on margin. For example, you can purchase shares of the SPDR S&P 500 ETF (NYSE: SPY) on 30% margin, empowering you to purchase $333 worth of SPY shares with just $100, allowing you to create your own leveraged position up to as much as 3.33x if desired.

But while using margin to create their own leveraged positions increases the risk to investors personally, it does not necessarily put the entire stock market at risk.

Why, then, are leveraged ETFs so threatening? Its because of the way they achieve their gearing: through derivatives.

Yahoo! Finance describes the composition of the 2x leveraged SSO:

The investment seeks daily investment results that correspond to two times (2x) the daily performance of the S&P 500 [index]. The fund invests in securities and derivatives that ProShares Advisors believe, in combination, should have similar daily return characteristics as two times (2x) the daily return of the index.

This creates a lot of room for error in judgement and unforeseen market movement, which could cause the SSO to fall out of step with the S&P. A leveraged ETF does not buy the index it is tracking on margin. If it did, there would be no problem of falling out of step with its underlying, since it would own the underlying directly.

Instead, a leveraged ETF does not own the underlying directly, but uses futures contracts and options either in whole or in part to replicate the movement of the underlying. The only problem is that futures and options are separate markets unto themselves, whose prices are set not just by the underlying index but also by their own supply-demand fundamentals.

In other words, even if the S&P 500 index moves up 1%, its futures and options might move only 0.8% if investors arent convinced of the rally, or may even move more than 1% if investors pile into futures and options with enthusiasm. As such, leveraged ETFs can be decoupled from the underlying they are supposed to be tracking.

Compounding this decoupling risk is that leveraged ETFs come with supply-demand fundamentals of their own, where high demand drives their share prices above and low demand pulls their prices below their underlying index. So not only can distortions creep into the futures and options used by the leveraged ETFs, but distortions can creep into the ETFs themselves during periods of very high or very low investor interest.

Ultimately, a leveraged ETF is a copy of a copy of the original. That is, it is based on futures and options which are themselves based on the original index putting investors two layers removed from the original.

If you want to create a safer and sounder marketplace, Fink admonished, it has to be at the product level. In other words, without so many layers between the underlying investment and the investor.

Do We Really Need Them?

For all the risks inherent in leveraged ETFs, one might wonder if we even need them. The simple answer is no, we dont. If you have a margin account with your broker, you can create your own leveraged position by purchasing the underlying instrument on margin, as noted in the above section.

In fact, purchasing on margin allows you to create your own leveraged position on just about any stock out there, including individual companies for which no leveraged ETFs exist. You can create your own 2x Apple position or 2x Tesla position, giving you twice the profit on the way up; but of course, it also exposes you to twice the risk coming down.

What is more, in leveraging individual stocks, you are investing in the underlying directly. There is no copy of a copy here, not even a one-layered copy you hold the original itself.

Three Advantages of Leveraged ETFs

So if traders can creates their own leveraged positions using margin, why are leveraged ETFs so popular? Three reasons, mainly:

1) The first applies to smaller investors, particularly those who do not have margin privileges. If all you have is a cash account, you are not allowed to purchase stocks on margin, locking you in to a 1:1 ratio at all times. For these investors, purchasing a leveraged ETF is the only way they can increase their leverage.

2) The second reason they are so popular applies to larger accounts and institutional investors who aim to achieve greater returns for less money. Lets compare the simple S&P ETF SPY priced at $191.38 a share to the 2x S&P ETF SSO priced at $109.85 a share as of yesterdays close.

Notice the advantage in their prices? While the SSO gives you twice the percentage return as the SPY, it does not cost twice the price. In fact, SSO costs only 57.3% the price of SPY. Leveraged ETFs thus allow you to earn the same dollar-return for less money.

For example, to earn $1 profit on the SPY, it would have to rise half a percent 0.5225% to be more precise. Such a rise would lift the SSO by twice the percentage, or 1.045%. Yet 1.045% of the SSOs price of $109.85 equals a dollar-gain of $1.1479. So where a move on the SPY generates $1 in profit, that same move generates 14.79% more in returns on the SSO.

3) The third reason leveraged ETFs are popular is in reducing risk, especially when using inverse ETFs, arguably the most popular of all leveraged funds. These funds point in the bearish direction, rising in value when the market falls.

Essentially, being long an inverse ETF is the same as being short its underlying, but with one critical difference.

When you are short a stock, you are exposed to unlimited loss if the stock skyrockets upward, as there is no limit to how high the stock can go. In contrast, when you are long an inverse ETF, your loss exposure is limited, since the most the ETF can fall is down to zero.

Thus, where a $10,000 short investment in SPY can lose you tens of thousands of dollars in a protracted bull run, that same $10,000 long investment in ProShares Short S&P 500 ETF (NYSE: SH) can lose no more than $10,000, since SHs price cannot fall below zero.

Many institutional investors will thus use inverse ETFs as a hedge against standard ETFs, gaining the advantage of limited downside risk while still gaining unlimited upside potential.

Leveraged ETFs and You

In the end, leveraged ETFs are investment tools like any other. A chainsaw has great advantages over an axe, but with greater dangers, requiring different handling procedures.

Leveraged ETFs are no different. They offer unique advantages, yet with unique dangers of their own. Each investor must study the particular ETF he or she is interest in, comparing its performance to its underlying over a period of years.

Does the ETF perform as it should? Does it ever deviate from its intended performance? If so, at what times? Sometimes a deviation can be advantageous if its in the right direction.

Study not just its performance by itself but also in relation to its underlying index and to other ETFs. Remember that like a tool, there are certain ways leveraged ETFs must be used and ways in which they must not.

And if ever you are uncomfortable with them, know that they are not essential. You can still trade quite successfully without them.

Joseph Cafariello

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