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The Dangers Of Triple Levered ETFs

In a previous article , we explained why “buying oil” using ETFs comes with an overlooked set of complications. Well, things get even more messy if you want to amplify returns using leveraged ETFs. Investors should completely avoid trading any type of ETF, levered or unlevered, unless they understand exactly what’s going on under the hood. And that means actually taking the time to read the mammoth prospectus of the product in question. We know most amateur traders never bother to look at a 190-page prospectus. And so, with the recent popularity of oil gambling , we thought it prudent to dissect the triple-levered oil ETN – the VelocityShares 3x Long Crude Oil ETN (NYSEARCA: UWTI ). We can only hope that a few of you will listen to our warning and not burn through your precious account balance in the levered oil casino. To be clear, ETNs like UWTI are technically not ETFs. ETNs are “exchange traded notes.” An exchange traded note is a senior, unsecured debt security that a bank issues. Here’s a quick review of what these debt terms mean: These notes are tied to a benchmark. The bank promises to pay the investor the performance of the benchmark minus fees. UWTI is the Credit Suisse backed, 3x levered-long crude oil ETN. It tracks the daily movements of the S&P GSCI® Crude Oil Index while offering three times the index’s daily gain or loss. This means that if the oil index rallies 1%, UWTI should rally about 3%. And if the oil index falls 1%, then UWTI should fall about 3%. Keep in mind that the oil index itself does not track the spot price of oil perfectly. It suffers from the same problems we outlined here due to the “roll effect” in the futures market. You can see below that the index never really recovered from the 2008 fall. Click to enlarge Oil’s price fluctuations are volatile as it is. But if you throw 3x-leverage on top of them, you’ll get returns more unpredictable than next week’s lotto numbers. That’s what you’re facing when trading something like UWTI. This unpredictability is due to something called volatility drag. Vol drag is a well-known concept in professional quant land. It occurs in all price series due to negative compounding, but its effect is exacerbated and easier to see in a levered ETN like UWTI. Vol drag is not as complex as quants make it out to be. To understand vol drag, all you need to know is that a loss hurts more than a comparative gain. Imagine your account earns 10% one week and loses 10% the next. If you started with $100, your account would go up to $110, and then down to $99. The result would be a net-loss. You do not end up break-even and back at $100 as many would believe. Negative compounding prevents that from happening. The reality of negative compounding is what creates vol drag. The more price fluctuates up and down, the more you lose out. And if you take this same situation and apply 3x the leverage to it, the downside becomes even worse. Using the 3x-levered UWTI as an example, let’s say the oil index started at $100, gained 10% one day and then lost 9% the next. This would translate into UWTI gaining 30% on day 1 and falling by 27% the next. For simplicity reasons, let’s say that UWTI is also priced at $100 a share. The chart below shows the final values of the oil index and the leveraged ETF. The index ends up right around where it started. But UWTI falls lower than the index and actually finds itself underwater! The leverage embedded in UWTI causes this underperformance, which then compounds over time and has a large negative effect on total returns. Many investors fail to realize that placing a long oil bet in UWTI is far more complex than guessing if the price of oil will be $20 higher or lower next year. These gamblers that are long UWTI are also making a realized volatility bet. Realized volatility is a quant measure for how much price oscillates up and down. If price oscillates wildly, realized vol will be high. If price moves smoothly in a slow “drip drip” fashion, then realized vol will be low. The higher realized volatility you have, the more vol drag you get. And as we saw above, vol drag is not good for returns. Going back to our oil example, if oil rises and the path is smooth, then the uninformed gamblers can thank lady luck. UWTI will greatly outperform by avoiding vol drag. But if the path higher is noisy with wild oscillations, UWTI will track prices horribly and suffer in performance from major vol drag. The graphs below illustrate this effect: Click to enlarge In both these examples, the oil index goes from 100 to about 131. But they take very different paths to get there. In the example on the left, the index finishes at 131 in a smooth “drip drip” fashion. UWTI finishes around 171. The gambler outperformed. Index 31% gain. Gambler 71% gain. Fire up the jets to Cancun baby! On the right, the index finishes at 131 as well, but the path looks more like a hi-speed roller coaster ride. In contrast to the smooth scenario, UWTI finishes right around 100. Uh oh. Index 31% gain. Gambler 0%. No vacation this year. So even though the oil index finished higher, UWTI made NO money at all. Zip. Nada. Zilch. And here lies the plight of gambling with levered ETFs. If the price path is noisy and jagged, you end up with poor results, even if you were ultimately right on the direction of the index! If you’re wrong, and the oil index finishes lower, forget about it. Your account is taking heavy damage and your spouse is about ready with the divorce papers. The administrators of the UWTI ETN actually talk about this in the prospectus, but of course, no one reads it. “Daily rebalancing will impair the performance of the ETNs if the applicable Index experiences volatility from day to day and such performance will be dependent on the path of daily returns during the holder’s holding period. At higher ranges of volatility, there is a significant chance of a complete loss of the value of the ETNs even if the performance of the applicable Index is flat.” If you want to compete in this game over the long run, then stick with trading outright oil futures rather than UWTI, the VelocityShares 3x Inverse Crude Oil ETN (NYSEARCA: DWTI ), or even The United States Oil ETF, LP (NYSEARCA: USO ). Don’t gamble. If you’re unfamiliar with futures and how they work, we wrote a special report on them specifically for beginners. Good luck out there. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Generating Income From Unlikely Sources: Financial Advisors’ Daily Digest

SA Dividends, Income & Retirement Editor Robyn Conti here, subbing in for Gil, who’s observing Passover this week. I’ll do my best to fill his very talented and knowledgeable shoes, and continue to keep you up to date daily on the latest FA analysis and news here on Seeking Alpha. Generating income these days is more difficult than ever due to the low rate environment, but that hasn’t stopped masses of investors from jumping with both feet into income investments that are too costly relative to their yields. Joel Johnson from True-Bearing.com emphasizes the importance of helping income-oriented clients invest for specific outcomes, and talks about how those solutions are more likely to be found in more “off the beaten path” investments, which present profit-generating opportunities for advisors: Outcome-oriented investing, once dominated by institutions offering low cost defined benefit plans, is a challenging job… Investment advisors can now create risk-aware portfolios designed to meet the specific income needs of their clients. The portfolios contain funds that invest in non-traditional sources of income. The portfolios should feature investments that are not overly expensive. Investing in themes is integral to generating alpha and hedging your portfolio against macroeconomic changes…” Harry Long’s article on ETF dividend strategies dovetails nicely, proposing several ideas for seeking out alternative income instruments while avoiding volatility. In contrast, on the subject of outflows from income investments, if you or your clients have muni bond funds coming due in the next few months, now’s the time to take action. SA contributor Patrick Luby highlights an historical summer trend in muni bond redemptions , per Bloomberg: … this year is expected to follow the same pattern, with $38.2 billion rolling off in June, $33.5 billion in July, and $29.9 billion in August. (The monthly average this year is just under $26 billion.) Forecast redemptions include maturing bonds as well as bonds that have been advance refunded or current refunded and are expected to be called away. For those fond of quick math, that’s more than $100 billion in redemptions — quite a round, and a rather hefty, number. Luby points out that, while reinvesting principal is generally an attractive benefit of owning individual muni bonds, due to the current rate situation and economic uncertainty, advisors and their clients may be unsure how to, or even if they want to, reinvest. He suggests those who have bonds coming due (maturing or pre-refunded) in the next several months consider the following: Changing asset allocation by using redeemed municipal bond proceeds to invest in another asset class will cause a shift in the overall portfolio risk profile, and should not be done unless called for by the investment plan. Don’t wait for the principal to be returned to you to consider what to do. Due to the volume of principal that will be seeking reinvestment, muni bond investors may find themselves competing with each other for a limited supply of appropriate bonds. Investors in high-tax jurisdictions with a preference for in-state double-exempt bonds may find their options even more severely reduced. Consider making provisions for reinvestment in advance of your bond’s redemption date. Pay attention now to the new issue calendar for appropriate issues that will settle after the maturity date of your maturing/refunded bond. As an alternative to individual bonds, you may wish to consider using a municipal bond ETF to maintain asset class exposure while waiting for a suitable replacement security. (To learn more about doing this, read my recent article about using duration as a guide to selecting municipal bond ETFs, available here .) These are definitely items of importance for advisors and muni bond investors to keep an eye on should redemptions proceed as forecast. Finally, since there appears to be quite a hefty focus on oil, where it’s headed, and the frothy politics involved therein, here are several stories offering a variety of views and insights on the volatile commodity: Daniel Jones takes a particularly bullish view on oil . However, Simply Investing says don’t expect the rally to last for long . The Heisenberg breaks down the nefarious geopolitics of oil price movements . Resident SA commodity expert Andrew Hecht explains how to read the “tea leaves” for crude following the OPEC stalemate in Doha earlier this month.

The Future Of Beta – Slip Sliding Away…

Value, momentum, size, quality, volatility, etc., as factors in investing are quite popular. They’ve produced significant outsized returns relative to benchmarks. Now, we even have Smart Beta funds and ETFs popping up all over to make taking advantage of factors super easy. That brings up the critical question every investor interested in taking advantage of factors in their portfolio should ask – will the outperformance of factor investing continue in the future? Here I’ll take a look at a recent post from Alpha Architect that addresses this question. In short, investors should expect past outperformance to decrease in the future. Basically, there are two reasons why outperformance could go away; data mining (the factor is not real and just an artifact of the data) and arbitrage (basically investors becoming aware of the anomaly, investing in it in a big way, and thus it disappears). The Alpha Architect post references a study that looked at out of sample performance of factors. Below are the results. Basically, out of sample returns are lower than what the historical results had shown. The returns were about 40-70% of what they were in the past. Sobering. But as I’ve discussed on the blog in the past, some factors are better than others. In another post , a bunch of factors are analyzed and the only two sustainable ones are value and momentum. This is the reason all the strategies I use are primarily focused around these two factors. But one of the reasons that value and momentum work is that they come with periods of awful performance, absolute and relative, and drawdowns. All of which make them very difficult to stick with over the long term. And if history is a guide, investors should expect their relative outperformance to decrease going forward as more investors become aware of them. In a way, these factor strategies are even harder to stick with than just simple buying and holding of traditional index products. When you’re indexing at least you’re doing no worse than the index! There is no FOMO (Fear of Missing Out). If you’re not willing or able to tolerate underperformance, potentially for long periods of time, then you won’t be successful with factors. But I think the are a several things investors can do to increase their chances of success going forward. Reduce expectations: I always reduce potential outperformance by at least half when I look at implementing a strategy. Diversify: Use multiple strategies – buy and hold indexing, TAA, smart beta, individual stocks. There’s a very strong chance at least one of the strategies will be outperforming, thus increasing your chances of sticking with your program. It doesn’t and shouldn’t be all or nothing. Stick with what works – Value and momentum strategies have stood the test of time… at least so far. Dampen portfolio volatility with bonds. Reduce noise – There is a lot of noise in markets today. Investors need to work hard to tune it out. Try and go 1 month without looking at the market. Most investors I know can’t go a week. Have an investing process – Investing your money shouldn’t be haphazard and random. As with many things in life, having a system and process will help you achieve success. What are your goals? How does your portfolio match those goals? When do you rebalance? What strategies are you implementing and why? Do the same things at the same times on a regular schedule, etc… In summary, factor outperformance could very possibly decrease in the future. But they are still likely to be very powerful wealth building strategies if investors can stick with them and not expect the future to be exactly like the past.