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Here’s Why Most Investors Should Avoid Leveraged ETFs

Monday, November 21, 2016 7:49
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From Moby Waller: Exchange-traded funds (ETFs) are growing in popularity among traders and investors all the time. ETFs offer fantastic flexibility and the ability to trade U.S. sectors, international stocks and commodities all in your brokerage account (including IRA accounts).

Moreover, many have options trading available and are shortable.

However, there is one group of ETFs that I must caution you about, if you are going to hold a position more than a day or two:  Leveraged, Ultra and Inverse ETFs.

Leveraged and Ultra ETFs attempt to multiply the returns of an index or security, while Inverse/Bearish ETFs look to profit from opposite moves. The 2x, 3x, 4x leveraged gains these ETFs target, using derivatives, are tempting to many investors.

But these kinds of ETFs are a dangerous game to play  ̶  and I have a better method that ensures you won’t miss out on gains due to a possibly faulty investment instrument.

Why These Are ETFs to Avoid

There have been many articles written in the past that claim these types of ETFs always underperform the market badly over long time frames. However, in my research, that is not always true.

Some do deliver the 2x, 3x leveraged moves they claim to.

But others lag badly and don’t deliver the expected results. It’s a mixed, volatile bag,

Additionally, Leveraged ETFs are expensive, because they do many transactions  ̶  they generally have about 2x the normal expense ratio that regular ETFs do.  This will chip away at your investment results over a longer time period.

I would advise investors and traders to avoid the Leveraged/Ultra/Inverse group for more stable and predictable alternatives.

Instead, I recommend that you utilize options available on the “pure” underlying ETFs to achieve the desired leveraged.  You then don’t face the risk of the ETF drastically underperforming its benchmark.

Let me give you an example that shows the danger of Leveraged ETFs, such as missing potential gains:

VanEck Vectors Junior Gold Miners ETF (NYSE:GDXJ) replicates the performance of the MVIS Junior Gold Miners Index. This ETF has been one of the big winners of 2016, up 79% year-to-date.

Meanwhile, there is a popular leveraged ETF that seeks to achieve 3x (or 300%) of the daily performance of this same MVIS Index. It is called Direxion Daily Junior Gold Miners Index Bull and Bear 3x Shares (NYSE:JNUG).

JNUG is up 122% year to date  ̶  this means it is only delivering 1.5x times leverage on GDXJ, not the 3x it attempts to deliver.

If JNUG had actually delivered 3x gains, the ETF should be up 237% this year. That is a lot of profits left on the table in 2016 for investors and traders in JNUG.

Instead of trading JNUG, if you had purchased in-the-money (ITM) call options on GDXJ, you would be achieving much better leverage results on the gains it has made this year.

In-the-money options act as sort of a leveraged stock substitute, for a low cash outlay and limited risk compared to the underlying ETF.

They represent 100 shares of the underlying security, and have a small amount of time premium/decay (Options Greek Theta) and a high bang-for-the-buck (Options Greek Delta).

In addition to sometimes underperforming their stated objective badly, Leveraged ETFs also tend to perform poorly in a volatile, range-bound market.

We may be facing such a market in 2017, with the new president and possible Fed moves creating uncertainty.

High Level of Caution

Here is an example of how they can perform poorly in a range-bound volatile market:

The SPDR S&P 500 ETF (NYSE:SPY) seeks to give results equal to the S&P 500 Index.

From August 2015 to April 2016, the broad stock market S&P 500 Index was volatile and range-bound, but ultimately ended up back where it started.

During this time frame, there were a lot big moves in both directions, but the SPYders ended nearly flat overall, down 0.23%.

Two popular S&P 500 Leveraged ETFs are ProShares Ultra S&P 500 (NYSE:SSO), which targets 2x the index return, and ProShares UltraPro S&P 500 (NYSE:UPRO), which seeks 3x the return.

By the way, SSO has an expense ratio of 0.89% and UPRO has one of 0.94%  ̶  both much more expensive to own than SPY, which has an expense ratio of 0.10%. This will hurt your investment results over the long run.

You might expect that over this August-to-April period, SSO would be down twice as much as the market and UPRO down three times as much.

But SSO ended up down 1.05% and URPO was down 4.4%. 

This means their losses were 4.5x and 19x worse than the underlying pure S&P 500 ETF — not the targeted 2x and 3x.

So in summary, I advise a high level of caution when investing in or trading Leveraged/Ultra/Bearish ETFs, and most investors should stay away from them 100%.

These are ETFs to avoid. I instead would advise you to use the basic underlying ETF, the pure sector plays. And if you are looking for leverage and outsized gains, utilize in-the-money options on them instead.

This article is brought to you courtesy of Wyatt Investment Research.

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