Frenzies

 By Guest Blogger Doug Rowat

When a market, or at least a particular area of a market, gets preternaturally hot and values overinflated, strange things start to appear. Odd and granular products emerge—products that, at first glance, seem as if they just can’t actually be true. We’ve seen enough examples of these within the real estate market—shall I mention micro-condos?—so I’ll highlight an example from an entirely different market to prove that the strange products that emerge from frenzies are really all the same, they’re just branded and packaged differently.

After being left for dead in the mid-90s, the Canadian sports collectible market has staged a comeback of sorts. One of the key drivers of the market’s resurgence has been the rise of Edmonton Oilers star Connor McDavid. No doubt he’s an outstanding player and his incredible skills have dazzled us all year, but he has played less than two NHL seasons and if there are a couple of things we know for certain about the NHL it’s that its highly touted players often don’t realize their full potential and, even if they become stars, they tend to get knocked around so often that their injuries significantly hamper their careers (Mario Lemieux, Eric Lindros and Sidney Crosby, to name but a few). McDavid’s already missed almost half of the 2015–16 season with a broken collarbone. However, despite all of the unknowns and clear risks, McDavid has become such an inflated and hyped commodity that the release of the below collectible was deemed viable:

“Game-Uased Ice” (i.e. water)( from a Connor McDavid Hockey Game selling for up to $180 a Piece.

Source: PuckJunk.com

As a portfolio manager, we see similar unnecessary and highly speculative products released all the time, particularly in the area of the market that Turner Investments focuses on: Exchange traded funds, or ETFs.

Generally speaking, ETFs are wonderful. They provide diversification, low cost, transparency and tax efficiency. As a result, the US ETF market has grown rapidly from less than US$1 trillion in assets in 2009 to more than US$2.5 trillion at the end of last year. Unfortunately, this growth has spawned some questionable products.

We recently learned, for example, that the SEC may approve 4x leveraged ETFs. That’s F-O-U-R times leverage. Just in case equity markets weren’t unpredictable and volatile enough for you, along comes a product designed to really blow up your pacemaker. Previously, the most risk you could take with a US-listed ETF was 3x leverage, but in this new, post-Trump era of reduced regulation, 3x leverage, apparently, may be just too restrictive. Unsurprisingly, the SEC that may approve the 4x leveraged ETFs is now headed by Trump appointee and Wall Street lawyer Walter Clayton. When it comes to allowable risk, the sky could now be the limit. (We learned earlier this week from The Wall Street Journal that the SEC is now having second thoughts about 4x leverage. Could it be that the Trump administration is dealing with enough controversy at the moment?)

So how do leveraged ETFs work? Essentially, they use mechanisms such as swaps, futures contracts and derivatives to provide investors with 200%, 300%, or in the case of these latest ETFs, 400% of the daily performance (either up or down) of an underlying index. The key term, however, is DAILY returns. These are products that don’t necessarily amplify returns over the long haul, rather just the returns over one trading day. Suddenly, the concept of ‘volatility drag’ enters the picture.

Suppose you put $100,000 into an unleveraged ETF. If it experiences a one-day drop of 5% and a 5% gain the next day, you actually don’t break even, you end up with $99,750 or a $250 loss (-0.25%). But what if you were holding a 4x leveraged ETF under the same scenario? You’d end up with only $96,000 or a $4,000 loss (-4.00%). And this is only after the first two days of trading. You’re actually down 16x more than an unleveraged ETF! If this see-saw pattern continues, your portfolio will continue to diminish at a dramatically accelerated rate. The results can be devastating in a very short period even though the underlying market itself may only be rangebound (as with the above example), or in some instances, actually higher.

Then, of course, there’s also the possibility that your market-direction forecast itself is entirely incorrect. If you’ve picked a leveraged ETF geared to favour an uptrending market and the market goes straight down, you can rack up even more significant losses also incredibly rapidly. In the past 10 years, the S&P 500, for example, has actually recorded a weekly decline of 3% or more 47 times, so it’s not as if meaningful short-term downturns are black swans—they occur constantly. And during the credit crisis there was even a week where the US market dropped more than 18%. Imagine how you’d fare with a 4x leveraged ETF during any of these stretches.

Understand the limits of your market-timing skills. No one can accurately time markets on a short-term basis (particularly daily), and it’s also highly unlikely that you truly have a firm grasp on future volatility. Ask yourself why you’re really purchasing these leveraged ETFs? The answer is probably pure, emotion-driven greed.

But, contrary to the teachings of Mr. Gekko, when it comes to 4x leverage, greed is not good at all.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.