Leveraged ETFs: Dangerously useful capitalist tools

These Trojan Horses should be outlawed, but can help shaky portfolios.

WASHINGTON, October 9, 2012 – Today’s column will be a short one, given our rather windy but, we hope, instructive column yesterday. The reason for today’s brevity is quite simple. The market will be more than usually aimless today, we think, given that another earnings season is upon us, set to begin after the close today. HFTs and algos will be placing their bets on this or that headline, no one else will be playing, by and large, and so it’s best perhaps to stand back and mostly watch.

Which gives us time for a brief discussion about one type of investment vehicle that the Maven thinks should be outlawed: namely, the leveraged ETF. These things are slippery, dangerous, and frequently don’t track very well whatever index they purport to track.

Worst of all, retail investors used to have to meet stringent requirements to trade highly leveraged vehicles like commodities futures and the like, due to the risk of catastrophic losses inherent in trading that involves a high degree of leverage, i.e., borrowed stocks or money. But any average Joe or Josephine can trade leveraged ETFs without possessing any qualifications at all let alone a margin account. And that’s a problem. These beasts can get intense, moving rapidly up or down almost at a moment’s notice. This is, of course, one of the key reasons for messing with them. (You can never invest in them.)

Average investors, however, tend to treat these ETFs like regular stocks and their portfolios get regularly hosed as a result. They’re sort of like the Trojan Horse in a way. They’re useful for those who know what’s hidden inside, but dangerous to those who don’t.

For an example, let’s take silver. You can, of course, buy physical silver from any number of firms that specialize in selling the stuff. But if you don’t want to get involved in the various messinesses that are involved with holding physical silver, you can alternatively invest in the silver ETF, SLV, whose shares are backed by actual physical silver stored in vaults. The beauty of SLV—or GLD or IAU, the primary gold ETFs—is that you’re actually still holding physical silver. Except that it’s virtual silver, without the issues that physical silver entails.

But let’s say you’ve been bored by the market this year. (We have.) If you think silver is going up, but not fast enough for you to achieve your investment objectives, boy does Wall Street have a treat for you. It’s the double-leveraged (2X) silver ETF, ACQ. A share of ACQ—theoretically, at least—will move twice as fast as a share of SLV because the former is leveraged. In other words, and simplistically, this means that via borrowing and a few other tactics, ACQ will give you twice the move in SLV either up or down.

If you’re bullish on silver, you buy ACQ. If you’re bearish, you can short it. Voilà! You’ve got leverage at your service just like the big boys and without a margin account, too. Problem is, these leveraged ETFs more often than not don’t precisely track the direction of the commodity or index they represent. And further, particularly when a commodity is involved, the underlying contracts are “rolled over” and begin again at a new base point—something small investors don’t consider when they buy and hold these issues.

Tomorrow, we’ll tell you how to deploy these leveraged ETFs. If you use them at all. The only reason we’re bringing up these vehicles now—in spite of the fact we distrust them in the main—is that markets could get terribly volatile as we approach the elections, the potential “tax cliff,” the ongoing nonsense in Europe (will we see the revival of the drachma?), and the caprices of the murderous thugs who run Iran and Syria, at least currently.

Hedging your existing portfolios via the judicious use of leveraged ETFs could help save your investment percentages in this volatile environment. So we feel you should at least know how to use them if the situation arises.

FYI, we did get into the leveraged gold and silver ETFs yesterday (DGP and ACQ) with currently mixed results and only as a hedge. We’ll let you know how these work for us. Hopefully better than our LifeLock (LOCK) IPO from last week, which currently seems as if it’s in a race for the basement where lousy new issues tend to reside.

More tomorrow. Keep your powder dry today.

Disclaimer: The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate. He currently owns positions in DGP, IAU, ACQ, SLV, and LOCK, all of which are discussed in this article.

Positions mentioned above describe this author’s own investment decisions and should not be construed as either buy or sell recommendations. The current market is highly treacherous and all investors travel at their own risk, so caution should be exercised at all times.

Illustrations, charts, commentary, and analysis are only the author’s view of current or historical market activity and don’t constitute a recommendation to buy or sell any security or contract. Views, indications, and analysis aren’t necessarily predictive of any future market or government action. Rather they indicate the author’s opinion as to a range of possibilities that may occur going forward.

References to other reporters, analysts, pundits, or commentators are illustrative only and do not necessarily represent an endorsement of such individuals’ points of view. If specific investment vehicles are mentioned in any article under this column heading, the author will always fully disclose any active or contemplated investments in said vehicles.

Read more of Terry’s news and reviews at Curtain Up! in the Entertain Us neighborhood of the Washington Times Communities. For Terry’s investing and political insights, visit his Communities columns, The Prudent Man and Morning Market Maven, in Business.

Follow Terry on Twitter @terryp17

 

 


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Terry Ponick

Now writing on investing, politics, music, movies and theater for the Washington Times Communities, Terry was formerly the longtime music and culture critic for the Washington Times print edition (1994-2009) before moving online with Communities in 2010.  

 

 

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