Leveraged ETFs Part One
Jul 28, 2009
Posted by Jody Eisenman | Filed under Uncategorized
When I first starting trading (when I was in college back in the 1970’s), there were no trading vehicles that could mirror the stock market as a whole. If you were not an institutional investor, the only way to invest was either to buy mutual funds or purchase individual stocks. At some point in the 1980’s, the Chicago and American Option exchanges created options on the stock market as a whole. These products, which were used for both speculation and for hedging, became enormously popular among investors. This, in turn, led to creation of more products designed to pinpoint individual areas of investment. In 1993, the first Exchange Traded Funds, or ETFs, were created. These were traditionally index funds, based on various areas of the market such as technology or basic materials. Last year, the SEC allowed actively managed funds to be created and managed. This can be a very useful vehicle. For example, if an investor thought that health care was a good place to invest, one could buy a health care ETF, rather than buying an individual stock. Thus, an investor could essentially buy a publicly traded mutual fund with a relatively low expense ratio, rather than betting on only one company. However, since the companies that underwrite these ETFs receive management fees, there was constant pressure to increase the number of ETFs in the marketplace. Today, an investor can bet on hundreds of ETFs, ranging from broad market, mid caps, different sectors, commodities and even fixed income. In addition, one can actually bet on a decline without actually shorting by simply buying an ETF that mimics 100% of the index in question declining in value.
So, for example, if I thought the S and P 500 was going to rise, I could buy SPY. If I thought it was going to fall, I could short SPY, or simply go long the inverse ETF, SH. As an aside, the proliferation of these ETFs is a good reason why the SEC’s ban against naked short selling does not have the effect they thought it would. While precluding the naked shorting of individual stocks, investors can still bet against the industry as a whole buy purchasing inverse ETFs. Most of these ETFs are very liquid. For example, the ETF on the S and P (SPY) regularly trades over 200 million shares per day! This provides enough liquidity for almost any size buyer.
The creators of ETFs went one step further. They created “leveraged ETFs”. These ETFs use leverage to multiply the return on the index in question. Thus, one can purchase ETFs that will double or even the triple the performance of an index. For example, an investor could buy UYM, which is a leveraged ETF that doubles the return on the basic materials index. Thus, if that index went up 5% one day, the ETF should be up about 10%. Sounds simple, doesn’t it? Obviously, these leveraged ETFs are quite volatile and not for the faint of heart, but they seem to be pretty straightforward, right? Wrong. Just yesterday, UBS has essentially banned the purchase of any leveraged ETF for their retail clients. Edward D. Jones banned them earlier. FINRA has issued warnings against them. What’s going on? In part 2, I will explore the dangers of these leveraged ETFs, and why the returns are not quite what meet the eye.
