Opinion

Felix Salmon

The harm done by levered ETFs

By Felix Salmon
May 1, 2011

Kid Dynamite and The Analyst have taken issue with my post about levered ETFs. We’re all in agreement that they shouldn’t be held for a period of longer than 1 day. But their argument is basically that the SEC can’t and shouldn’t protect people from their own stupidity. Here’s the Analyst:

As should be extremely obvious at this point, understanding how these ETF’s work is not rocket science, and it does not take much time/effort to do. If you do a quick google search for “how do leveraged etfs work” returns a large number of posts, most of which answer the question with little ambiguity.

Let me put this as nicely as possible: You have to be self-defeatingly ignorant/naive/lazy to trade these things without learning about them. If you have an internet connection, you’d actually have to go out of your way not to pick-up some basic knowledge about how leveraged ETF’s work just by sheer happenstance. The information is EVERYWHERE, easy to find, and just as easy to understand for anyone capable of opening a brokerage account.

Except, if you go back a month to when KD last wrote about these things, you’ll find him linking to a column by Dave Kansas — the founding editor of thestreet.com, and about as veteran and admired a markets journalist as it’s possible to find. And he got it wrong, as the correction at the bottom of the column attests.

My point here is that if you want to find out how easy and obvious something is, you don’t first look for someone who understands it and then ask them whether understanding it is easy. Instead, you look at a broad audience of people who ought to understand it, and look to see what percentage of them actually do.

And if you look at the people who are investing in TBT, it’s clear that the vast majority of them do not understand how it works. For all that there are prominent disclaimers in the abbreviated summary prospectus about such things, those disclaimers are not preventing people from making long-term investments in a security which should never be held for longer than one day. They’re not working.

What worries me here is that we’re taking rules which apply to stocks and applying them to levered ETFs, even when levered ETFs are very different creatures from stocks. Stocks are permanent long-term stores of value — ownership stakes in something real in the world. Levered ETFs, by contrast, are pretty much guaranteed to go to zero eventually; the only question is how long they will take to get there. That’s not a problem for people who hold them on an intraday basis, as trading vehicles. But they trade on the stock exchange with a stock-like ticker symbol, and they look similar to unlevered ETFs which do things like replicate the S&P 500, and which really are long-term investments. So it’s easy to see where the confusion arises.

What I’m not getting from KD or the Analyst is any good reason why levered ETFs should exist. What purpose do they serve? If you want to make a leveraged bet on a certain asset, you can buy it or short it using borrowed money. These things are obviously harming a lot of people — the investors wielding billions of dollars who are holding them for long periods of times. Who are they benefiting? It seems to me that the cost of leveraged ETFs is greater than the benefit; that’s why I think the SEC should look into them.

It’s one thing allowing people to invest in individual stocks which can be highly risky investments — that’s fine, because there’s a strong social upside to allowing companies to raise capital on the stock market and allowing individuals to buy those stocks. But there’s no such social upside to levered ETFs, and if they disappeared tomorrow, anybody using them the right way could very easily put on the same trades just by using their margin account. So if there’s good reason to believe they’re causing harm, and no reason to believe they’re causing any good, why keep them?

Comments
11 comments so far | RSS Comments RSS

As your previous column pointed out — and as the Symmetric Info explain very well, a levered ETF is not the same thing as a self-leveraged position. A levered ETF maintains a position of constant leverage, making the overall result exponential. A standard levered position is simply a multiple of an unlevered position. As Symmetric Info explains, leveraged ETFs do better than leveraged positions when the trend (n either direction) is more powerful than the volatility. One can’t get that same result for oneself without adjusting the position day by day.

Posted by RussAbbott | Report as abusive
 

So, since Dave Kansas demonstrated gross incompetence in failing to understand something that he absolutely positively should have understood, it means… well, I don’t think it means anything other than that you should be careful reading Dave Kansas and taking his advice!

Herb Greenberg has also, on more than one occasion, demonstrated misconceptions about the simplest of ETF mechanics (creations/redemptions, rebalancing, etc). Herb is a smart guy who has been around markets forever – does that mean that no ETFs should exist since even Herb can’t understand them?

Felix, I think there’s two different arguments here: 1) whose fault is it that people do ignorant/lazy/stupid/greedy things? that’s kinda what I’m addressing. 2) The question you now seem to be asking is: “Why should these products exist in the first place?”

well, that’s a different question, which is why I haven’t answered it! I am generally not against giving grown adults the freedom to trade products that do EXACTLY what they aim to do – and which are clearly explained in the documentation – which is what these leveraged ETFs do. That’s the first and foremost important thing: these products do what they are supposed to do. If they didn’t, your argument would be an easy one.

Now – could you short $200k TLT instead of buying $100k TBT? Maybe – some people can – not everyone can. You are arguing (I think) that this additional “freedom” we are giving to investors is doing more harm than good. That may in fact be true, but it gets back to the question I was arguing – just because it does Y dollars of “bad” for the people who neglect to read the easily available information telling them what the product does, and only X dollars of “good” for traders who use the product correctly (and you’re assuming that X is less than Y) doesn’t mean that the product should be banned – in my world… In fact, much of “Capitalism” is like that. To put it harshly and simply, I don’t believe that people should be over-protected from their own stupidity.

just to repeat – the important points: no one is being coerced – no one is being misled (Except by Dave Kansas’s original, now corrected, article), no one is having the truth buried in impossible-to-read legal documents. The facts are right out there in the open, in bold face and italics, for anyone who so desires to read them.

http://www.proshares.com/funds/tbt.html

http://www.proshares.com/funds/performan ce/the_universal_effects_of_compounding. html

Posted by KidDynamite | Report as abusive
 

ps – Ditto Russ Abbott’s comment reply!

Posted by KidDynamite | Report as abusive
 

Felix – I think in your last paragraph you’re starting to get close to the underlying question, which The Analyst wrote, and KD echoed in his post and in these comments:

“Ultimately, the question we must ask ourselves is whether we want regulators to protect us from predatory and unethical behavior from issuers, brokers, and other Wall Street interests seeking to profit from illegal asymmetric information, or do we want them to protect us from our own laziness, naivete, and ineptitude.” – The Analyst

You should write a post on THAT topic, as it a foundational question for a lot of what you write.
Opinions on that point differ, and probably closely align with one’s larger political and economic worldview.

Posted by SteveHamlin | Report as abusive
 

Dunno if the one day only rule is really valid. Leveraged ETFs lose value when they oscillate, which means they are awful long term bets, but as long as they are moving in one direction ONLY there is plenty of value in holding them for a few days. Holding them overnight is just a bet that the trend holds overnight (assuming it’s going the right way for you of course.)

Posted by AbeB | Report as abusive
 

As AbeB says, they pay better than equivalent straight leverage if: A. the underlying trades continuously up. or B. The underlying trades continuously down. In order to replicate them with straight leverage, you would have to be able to reinvest the additional MTM picked up on any day, which most margin programs do not allow you to do unless you trade all the way and out to pick up the cap gain (and generating trans costs). Alternatively, no matter how much the underlying goes against you, you can not lose your complete principal or be subject to a capital call.
However, explaining path dependency to most of the investors who buy these would be a hopeless exercise.

Posted by Derrida | Report as abusive
 

Others have already pointed out reasons why leveraged ETFs are different from straight up leverage orders. It should also be noted that shorting, for example, is not always possible, and leveraged short positions sometimes run the risk of being cut when the shares can no longer be borrowed. Leveraged short ETFs will resolve that uncertainty.

On the point of decay – even though these instruments decay over time, over a short term period (say, a week) the decay is often negligible unless there are some truly massive moves. So I’m not sure if I agree that they should never be held for anything more than a single trading day, which is your argument Felix. A whole month, perhaps, but to say that they’re toxic beyond the trading day seems to me to be quite exaggerated.

Posted by MarshalN | Report as abusive
 

We (the people of this country) need to shut you financial people down. You’re all off in your own little worlds of financial tools that are nothing more than made up games to screw each other with and feel real smart about it. The markets are so convoluted with crap now that it can’t be fixed. It must be replaced.
tic-toc, tic-toc.

Posted by tmc | Report as abusive
 

@SteveHamlin, they’re two sides of the same coin. Virtually any case of predatory and unethical behavior on Wall Street can be spun as naivete and ineptitude on the part of the investor.

Posted by FelixSalmon | Report as abusive
 

I don’t even agree with AbeB here; it is simply not the case that an asset with positive convexity automatically “should never be held for longer than one day”. This is similar (though not identical) to buying puts; you’re protected from a really big drop, but you have an asset whose median path will be down. In a rational, risk-neutral martingale kind of world, TBT will drop with probability greater than 50%, but will exhibit positive skew, i.e. will rise, conditional on rising, more than it drops, conditional on dropping. If you’re going to argue that it’s inherently something that “should never be held for longer than one day”, you need to invoke something outside of that idealized framework.

I suspect, even in the real world, that it in fact is an appropriate instrument for certain reasonable investors, and that any fault to be found with it is that there are people buying it without understanding it. (More so than with most instruments, I mean.) I expect that, even in those cases, the risk profile isn’t egregiously different from what they’re pursuing; there may be an insurance product layered on that they don’t realize they’re paying for, but it’s reasonably priced. This is nowhere near as bad as the rolling futures gold ETF that has been discussed here before, which genuinely is a bad instrument for long-term holding for anyone in any circumstances.

Posted by dWj | Report as abusive
 

Out of the universe of leveraged ETFs I can think of one very large and prominent category that has a valid purpose. The purpose is capital preservation, and the category is the leveraged inverse ETF.

First, understand my point of view. I have self-directed investments, but do not desire to allow trading to take over my life. I am not of the speculative mindset and do not try for lopsided killings. I would prefer to pick good stocks and buy and hold, but a bear market makes that a less-than-optimal strategy. Enter the leveraged inverse ETF as a hedging tool, doing the thing it was designed to do.

Once intellectually in command of the leveraged inverse ETF, I have new freedom. In a down market I am still free to assemble my portfolio of equities and conventional ETFs and hold it, rebalancing as my views of the long term gradually change. I can keep my shares and collect dividends. On up days I do not have to own any shares of my favorite leveraged inverse ETF. My thought is that I am always looking for a good reason to get rid of those shares, so I unload them as soon as things start looking bullish. Good days take care of themselves.

On a down day, one that I had a strong sense in advance was going to be a down day, I can load up on leveraged inverse ETFs and do better than just avoiding losses. Those days are pretty rare, but they do occur.

More frequently, in choppy trading, when the market dynamic is obscure, even baffling, buying into a leveraged inverse ETF can neutralize change in the value of my portfolio. I can just decline to make wagers. I can have no large gains or losses for the entire confusing, inscrutable day. If, on a particular day, I’m tired, or sick, too occupied with my day job or playing with the grandchildren, I can just set the market down, with fair safety, by neutrally hedging my portfolio first thing in the morning and selling out my position in an inverse leveraged ETF at 3:59 PM.

Case in point. Today, I couldn’t understand the market. Asia and Europe were down, but good news came from Michigan (consumer confidence), Chicago (purchasing managers) and Washington (personal income). So, things were unclear. Looked like it might go up, but ended up going down. I hedged out of the whole mess using ProShares SDS, and got some work done. Had I done nothing, I know I would have lost about 2.50%, because my portfolio tracks the S&P. As it stands I lost 0.08%, a very small amount. I sold every share of SDS at the end of the session. Monday might as well be years away.

I think leveraged inverse ETFs can reduce risk, ulcers and the amount of time you have to spend babysitting your portfolio, assuming that is not the thing you most love to do.

Posted by thiggins | Report as abusive
 

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