What if someone told you that you had an equal chance of quadrupling your money or of losing four times as much as your bet at the casino? This is essentially the bet that investors will make using two new leveraged exchange-traded funds (ETFs) approved by the SEC on May 2, 2017. The approval of the new highly leveraged funds caused a stir in the investing community, and interestingly enough, two weeks following approval, the SEC announced it would reconsider its approval of the quadruple-leveraged ETFs. At this time, the trading fate of quadruple or 4X leveraged ETFs on United States exchanges remains uncertain.
Whether the leveraged ETFs retain or lose their SEC approval, we think this provides the perfect opportunity to learn more about the risks of highly leveraged ETFs. Mainly because we believe these particular ETFs, the ForceShares Daily 4X US Market Futures Short Fund and the ForceShares Daily 4X US Market Futures Long Fund, are the most dangerous products out there.
What are Leveraged ETFs?
To understand leveraged ETFs you need an understanding of the word leveraged in the financial world. Leverage includes the use of borrowed money to increase the potential return on investment. If you hear a company is highly leveraged, the understanding is that the company has more debt than equity. A leveraged ETF is one that takes a traditional benchmark, like the S&P 500, and uses financial derivatives, products used for hedging or speculating on stocks, bonds and other types of investment instruments, and debt to magnify the returns of the index. This works both long and short.
Long holders make money when the underlying holdings of the ETF increase in value. In the case of an ETF leveraged against the S&P 500, this would be when the index goes up. Meaning, the total value of the 500 stocks in the index has grown. Investors in a short product are betting the inverse, that the underlying index will decline in value.
Losses can mount when investors are wrong and the losses can be exponential when leverage is a factor.
Read more: 6 Things Nobody Told You About Trading ETFs
What is a Quadruple-Leveraged ETF?
Leveraged ETFs work to keep a constant amount of leverage in a specific ratio. A 4X leveraged ETF would then stay in a 4:1 ratio, meaning the fund can quadruple the daily gains or losses of the index. These ETFs are different than the prior leveraged ETFs in that they are more levered than ever before. Previously, the most highly-levered ETFs tripled the return of an underlying asset.
The ForceShares 4X US Market Futures Long Fund will track four times the daily performance of the S&P 500. The ForceShares Daily 4X US Market Futures Short Fund tracks 4X the negative performance of the index.
Our Take on Leveraged ETFs
At some point, you have to question why we need to build these funds. Finding ETFs, or other types of investments with high potential volatility, without any leverage, is not hard to do. Overall the market has not been very volatile in recent years, and the use of leveraged ETFs could “spice things up” a bit, but not always in a good way.
Leveraged ETFs Are Not a Long-term Investment
Leveraged ETFs use daily futures contracts to amplify their exposure to a given index like the S&P 500. As such, they are not designed to track the longer-term changes in the index. Investors who try to use a leveraged ETF as a long-term holding are likely to be unpleasantly surprised by the results.
Leveraged ETFs Can Be Dangerous in the Wrong Hands
Think about the last time you mowed your lawn and maintained your property. You may have used tools like a lawnmower or chainsaw to make this job easier and more efficient. Some of these tools can be dangerous if misused or if used by someone who is not aware of the safety precautions needed.
These 4X leveraged ETFs work much the same way. There is nothing wrong with them per se. However, in the wrong hands, the results can be financially devastating.
4X Leveraged ETFs Are a Gamble
We do not believe these products are investing. Instead, we liken investing in highly leveraged funds to casino gambling. No one can accurately predict the movements of the stock market and we think highly leveraged products are comparable to betting on the market on steroids.
Some investors will let their curiosity or greed drive them to use maximum leverage to boost their returns. Investor’s ask, “What is the purpose of using these investments?” To answer their question, let us look closer at how 4X leveraged ETFs work.
Say you were to buy a regular non-leveraged ETF that tracks the S&P 500 index and it goes up 5%, your ETF would gain about 5%. Likewise, if the index drops 5%, the ETF would drop about the same amount.
With a 4X leveraged S&P 500 ETF, if the index goes up 3% on a given day, your ETF would increase roughly 12%. The same would be true for a 3% decline. You could lose 12% in a single day on a decline in the market! While sizable for a single day, a 3% index decline is not significant in the bigger scheme of things under normal investing circumstances.
Likewise, if you buy the short version of the ETF assuming a market decrease and you are wrong, your losses could be staggering in a very short period of time.
Our Investing Approach
We believe in a long-term investment approach. We invest to earn appropriate risk-adjusted returns that align with your unique time horizon and risk tolerance. Along with a rigorous analysis of the investment universe and their unique situation, the investments we select for our clients reflect this approach.
The new 4X leveraged ETFs, appeal to investor’s worst instincts and are more about making a big wager than about investing in order to reach your goals.
If you are looking for a proven strategy and a long-term partner to help you achieve your financial goals, please give us a call at 800-231-6409. We’re looking forward to getting to know you.