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Friday happy hour conversation in the Village reminds us why holding levered ETFs more than a day isn’t a good idea. Leveraged ETFs can suffer from disproportionate downside. Risks are added from levered ETFs taking on derivatives and exposure to debt markets.. Always consult your personal financial advisor before holding ETFs over the course of the long term. By Parke Shall Today we wanted to go over a topic that we were asked about on Friday at happy hour. Thom and I were having a conversation with someone who was talking about their portfolio to us. This person commented that they had been holding several leveraged ETFs over the course of months, and he did not understand why the moves that the ETFs were making did not seem congruent with the moves in the individual sectors that they represented. This brings us to a topic that we don’t think enough people know about or understand. Not all ETFs are created equal. Some ETFs are designed specifically to be held over the course of the long term. Good examples of these are ETFs like the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) or the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ), two different style unlevered ETFs that we have talked about in our last four or five articles. TLT tracks the yield on treasuries, and IBB is an unlevered ETF that tracks the biotech sector. Each sector has an ETF, or several ETFs, similar to IBB for biotech. We have heard a lot about IBB over the last month because biotech has crashed, so we’re using that as an example. ETFs like IBB are helpful in showing sector moves proportionate to the broader market, like you can see in the below chart. IBB data by YCharts TLT tracks 20 year treasuries and provides a dividend according to their yield. TLT joins a host of other ETFs, like the Vanguards High Dividend Yield ETF (NYSEARCA: VYM ) which are meant to and designed to be hold for the longer-term, and have minimal fees. They take a small management fee, but they can be good to hold for conservative investors over the course of long-term. Any type of ETF for bonds especially makes bond investing a little bit easier, as sometimes buying individual bonds can be too costly for retail investors. So let’s look at what makes leveraged ETFs difficult to hold for more than a day or two, and why they should not be traded over the course of weeks or months. A simple example is this. If you buy a $50 2x levered ETF that goes up 10% you’re going to see a return of 20%, and that ETF will be priced at $60. The next day, the ETF falls back from $60-$50, you would expect the underlying to be the same as it was prior to the first day. The problem is that the drop from 60 to 50 is only about a 17% drop, meaning the underlying would only need to fall about 8 1/2% for you to lose the same amount that you made when the market grew 10% in the day prior. This type of attrition makes these instruments difficult to hold over the course of weeks or months. This is why it is not uncommon to see splits of different natures, including reverse splits, take place in these instruments. Like the gentleman we were speaking to yesterday, one needs to be aware of the mechanics of how leveraged instruments work before making what we believe to be a terrible mistake in buying them and letting them sit in your portfolio unwatched. The same goes for ETNs (exchange traded notes) that have major risk to the debt that’s been issued by a bank (or other institution) that presents counterparty risk. Sometimes with ETFs or ETNs that have these characteristics, you wind up seeing charts like this. UWTI data by YCharts In addition a lot of levered instruments will rebalance or reset on a daily basis, meaning that if the markets are volatile and not moving in one set direction, you could wind up taking losses on a day where the sector or underlying appears neutral. Finally, one needs to realize that these type of instruments may achieve their leverage from utilizing derivatives like options and sometimes debt instruments. These types of risks are not suitable for those looking to buy and hold or those investing for the long term. Before picking up an ETF to hold for the long term, make sure to check with your personal financial advisor. Scalper1 News
Scalper1 News