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Why Levered ETFs Don't Need to Be Banned
This is from Stone Street Advisors
Felix Salmon wrote a post today in response to both my, and Kid Dynamite's
posts in response to his original post, wherein he said the SEC needs
to do more to protect retail investors from blowing themselves up with
levered ETFs. I certainly appreciate the open debate (and I hope our
readers do as well!), but it seems like Felix is still missing a few
things, and making a few factual leaps of faith, which I'd like to
discuss here.
He begins by asking how laymen could possibly
understand these securities if an (apparently, I'm not familiar with
the gent mentioned) qualified financial journalist doesn't understand
how they ETF's work:
Except, if you go back a month to when KD last wrote about these things, you’ll find him linking to a column by Dave Kansas — the founding editor of thestreet.com, and about as veteran and admired a markets journalist as it’s possible to find. And he got it wrong, as the correction at the bottom of the column attests.
I've read the article, wherein the author said:
Conversely,
the ProShares UltraShort S&P 500 (SDS), which makes a double bet
against the S&P 500, is down 40% in the past year, which compares to
a 13% gain for the S&P 500. That means the “double” bet against the
index is doing worse than promised, highlighting another risk for such
funds: They often fail to track their stated performance goals.
As
the correction added after publication (almost) admits, this is an
egregious mistake if it was made honestly, and a gross misstatement if
not. Either way, I can't find any way to excuse such ignorance from the
WSJ, The Financial Paper of Record, even with the correction. Everyone
makes mistakes, of course, but this isn't some casual blog post, or
tweet; its THE Wall Street Journal! Perhaps (some) financial
journalists should check with their sources and/or take a few more
minutes to learn about what they're writing before they hit the
"publish" button, but that's neither here nor there...
As both KD
and I have explained, the sponsors of these ETFs go to significant
lengths to explain they are designed to target 2 or 3x the DAILY
return of the index, therefore, comparing returns of the ETF and the
index on a longer time period is at best, apples and oranges. Felix
continues:
My point here is that if you want to find
out how easy and obvious something is, you don’t first look for someone
who understands it and then ask them whether understanding it is easy.
Instead, you look at a broad audience of people who ought to understand
it, and look to see what percentage of them actually do.
While
I agree that you don't ask your friend who's a Quantum Physicist to
explain how easy classical physics is to understand, if we look at the
"broad audience of people who ought to understand it" that Felix
mentions, they should, in fact, be able to understand concepts that
could be the basis for questions on the TV show "Are You Smarter Than A
Fifth Grader?" If adults with brokerage accounts who can get the
approval I mentioned in my last post from their broker to buy levered
ETF's (which usually requires a relatively substantial amount of money
and long-ish relationship) can't understand arithmetic, then we have a MUCH bigger problem to discuss than whether levered ETFs are or are not a good idea!
Felix's next non-sequitur is equally confusion:
And if you look at the people who are investing in TBT, it’s clear that the vast majority of them do not
understand how it works. For all that there are prominent disclaimers
in the abbreviated summary prospectus about such things, those
disclaimers are not preventing people from making long-term investments
in a security which should never be held for longer than one day. They’re not working.
In
his initial post, Felix said that since TBT (and thereby all levered
ETFs) are "intraday-only" trading instruments, the fact that the average
daily volume is only ~1/10th of the shares outstanding, that means 90%
of shares are held by people who aren't using them properly. This is
also a non-sequitur in and of itself, as example, see this paper on trading leveraged ETF's from NYU (pdf), which says:
The study also shows that leveraged funds can be used to replicate the returns of the underlying
index, provided we use a dynamic rebalancing strategy. Empirically, we
?nd that rebalancing frequencies required to achieve this goal are
moderate, on the order of one week between rebalancings. Nevertheless,
this need for dynamic rebalancing leads to the conclusion that leveraged
ETFs as currently designed may be unsuitable for buy-and-hold
investors.
That's only from the abstract to the
paper, but the point is that while 90% of the fund float may not be
turned-over each day, suggesting that is entirely from naive
buy-and-hold retail investors is itself incredibly naive. In a simple
regard, an investor can hold levered ETF's on a greater-than-daily basis
to make a longer-term bet on sector volatility, instead of whole-market
vol (see VXX, etc). Levered ETFs also give a trader/investor the
ability to get levered returns without having to deal with margin calls,
which in volatile markets is a great comfort, to say the least. One
does not need to be a professional trader to put-on such a trades, I
promise, as I'm not myself a professional trader (although I suppose a
decade+ in/out of markets, BS in Finance, and a few years working does
make me slightly more experienced than the average Joe...). I can't
quantify to what degree these levered ETFs are used by non-amateurs, but
I can all but guarantee that it is much greater than 0%, as there are
several reasons to hold them for greater than intraday.
Felix then
says he's concerned that ETFs are a problem because the same rules that
are applied to stocks - which have a positive social value in that they
represent ownership of tangible assets and help firms raise funds - are
being applied to ETFs, which have no such implicit value, social or
otherwise. He also says that these vehicles are mathematically
guaranteed to go to zero, which is not the case at all, at least not in
the way he puts it, which assumes that is the only option (over a
long-enough period of time this may very-well be true, but we are not
talking years upon years here).
To see how levered ETFs actually
behave, recall the graph from my last post of FAZ, the ultra-short
financial ETF v. the Financial SPDR, XLF***, which showed as XLF
increased over the past two years, FAZ decreased by even more. If we
zoom in on just the first three months of that series, we can see just
exactly what it takes for a levered ETF to "go to zero:" relatively
large swings and/or a relatively short period of time.
In
this case, it was both large swings AND a short period of time. FAZ
lost 47% of its value after just 5 trading days, over which FAZ's
average daily return was 2.7x that of XLF! You can see that during
these three months, there were some relative large corrections in the
opposite direction of the trend, for example after the first initial
dive to almost -50%, FAZ went up so that it was only -~30%. Because FAZ
was already beaten-down and returns are compounded, smaller decreases
in the index resulted in even larger gains for FAZ, driving it back up
almost as quickly as it dropped.
Generally speaking, only way for
an ultra-long ETF to go to zero is for the index upon which it is based
to trend downward over a period of time, with few and small upward
corrections relative to the downward ones. For an ultra-short ETF to go
to zero, as is almost the case with FAZ, the underlying index needs to
march steadily upward, with little downward corrections relative to the
upward ones.
Felix then says that since these securities trade on
the same exchanges as stocks, and have symbols like stocks, its easy to
confuse the two. I'm not even going to dignify that bullshit excuse
with a response.
Felix's ultimate concern is that he doesn't see why these levered ETF's should exist. He says:
What
purpose do they serve? If you want to make a leveraged bet on a certain
asset, you can buy it or short it using borrowed money. These things
are obviously harming a lot of people — the investors wielding billions
of dollars who are holding them for long periods of times. Who are they
benefiting? It seems to me that the cost of leveraged ETFs is greater
than the benefit; that’s why I think the SEC should look into them.
Well,
as I briefly discussed above, there are legitimate ways to use levered
ETF's as part of a reasonable, well-thought-out trading/investing
strategy. They can also be used for rank speculation, and there is
NOTHING WRONG WITH THAT, so long as anyone using them for that purpose
understands the possible consequences of so-doing. Second, I have yet
to see any conclusive evidence that any remotely significant and/or
widespread damage has been done to Joe & Jane Investor. Third, I
just don't see any sort of proof that the cost of levered ETFs outweigh
their benefit.
The fact of the matter is that retail investors can't just put on the same trade as a levered ETF without them; Reg T
prohibits it by limiting initial leverage. To (over)simplify, retail
accounts must put up at least 50% of the value of purchases in their
brokerage account within a certain amount of days, otherwise they will
have the position sold-out. Clients could gain greater leverage by
buying options, but I fail to see how that would be a less inappropriate
strategy for retail investors, as they have the same potential loss -
100% of the investment - but are even more difficult to understand than
ETFs!
So long as levered ETF's are not being sold by predatory
brokers trying to juice their commissions off unsuspecting and
unsophisticated clients, I don't see anything wrong with levered ETFs,
which as I said in my previous post, give clients the option to share in
the gains - as well as the losses - available to professional traders.
I'm glad Felix is asking these questions because apparently they have
not yet been sufficiently addressed, and its clear he is not the only
one out there who'd like some answers. However, just because he - and
others - don't have the answers, that doesn't make his conclusions
logical, let alone right.
I'm all for investor education and
protection from both unscrupulous tactics and illegal information
asymmetry, but neither of those things are part of Felix's argument for
greater regulation. Retail investors constantly complain they don't
have the same profit-making opportunities as professional traders and
investors, but look what happens when they do (if Felix's arguments are
to be believed); they not only squander and abuse it, but in so doing,
shirk responsibility and accountability for the consequences of their
actions.
News flash: With great opportunity for profit comes great
opportunity for loss. There is no such thing as a free lunch. There
is no risky return without the risk, etc, etc, you get the idea (I
hope!). If retail wants the opportunity to get rich through "smart"
investments and trades, they necessarily must accept the fact that they
may very-well get poor the same way.
*** XLF is not the index for FAZ but it is extremely close, so its used as a proxy for the Russel 1000 Financials
- advertisements -
1. Compounding.
and yes they work quite well over longer time frames during trending markets.
Maybe they should not be illegal, but instead of allowing banks to sell them, they should reflect their true character by only being available for purchase from the mobs in Las Vegas and Atlantic City.
... so THIS passes for banking and investment these days? IMHO time to break up the Wall Street bucket shops.
I completely disagree with this article. These products absolutely should be banned. If they aren't banned, they ought to require thorough disclosures and special trading approval (as happens with options).
You cannot expect the average retail investor to distinguish between stocks, single ETF's, and levered ETF's at first glance. Any product that has reams of underlying derivatives as the basis of its so called "tracking" should require the aforementioned special approval. Absent of that, all these crap products should be banned forever.
We need to restore confidence in the marketplace, and stop allowing the proliferation of new products (such as levered ETF's) that virtually guarantee large numbers of retail investors will get picked off.
Yes, please enable the socialist statist planners you support to control me, tell me what to own. Please protect me and remove me from the horrible misleading profits of AGQ held since June 2010. The comments I am reading are quite sickening. These type of people, and the same agenda promoted by the WSJ ignorance-in-print to further control what contracts I can or can not enter into? What is wrong with you people?! Look into it, ban it, regulate it...or maybe just let the market decide...
Agreed because if we'd let the market decide ETF's would be dead and buried already as their banks (Deutsche, JP Morgan etc) would have gone to the scrapheap 3 years ago, the banking system would have been cleansed of garbage bankers and we might have had a recovery by now instead of the slow burn ever deeper in debt faked recovery (the official unemployment index appears to track real unemployment as badly as these ETF's track the real indexes they're named after ...by the instrumentalists design?)
...we know as proven right across the globe the crony Regulators will not rock the banana/money boat (ie. do their fuking job)... so we'll leave it to the private sector to first be fleeced (the only way of exposing a fraud) and then sue the purveyors of yet another instrumentally designed pigs ear financial product
...judging by Shit Street Admonishers the crones of the industry have already begun their excusings and snake oil campaign to try to paint over the cracks and blame it on the silly investors (dumb 5th Graders) as they did derivatives, MBS's and Ratings Agencies
everyones problem but the designers and distributors of pigs ears
...keep it up Shaft Street Asswipes, you're doing a fab job of shooting yourselves in the foot ..."Hey ETF's are crap at tracking the Indexes they're named after, are you a dumb 5th Grader, but totally legit to keep selling crap" right?
Banned...please give people guns and booze first...worse products ever..
I think some need to be banned.. i was playing with HVU ETF (double leveraged S&P500 VIX), and the thing only tracks the VIX in the loosest sense of the word 'track'.
The thing doesn't track intraday or interday. Ignores some interday upgaps (and of course keeps all the downgaps). Intraday, many examples of the VIX it is supposedly tracking being up on the day, but the ETF is way down.
I dabbled in TBT and VXX and even read the prospectus for both but it was only after I constructed a spreadsheet and modeled daily fluctuations before I understood them. By the way the prospectuses are very misleading - giving up and down "hypothetical" 10 year projections! The mathmeticians who created these know that they will have nearly guaranteed 100% profit for every dollar that they sell as they inevitably grind their way to ZERO. It doesn't matter who holds them - as long as someone sells and someone buys they grind lower. They are ultimately a sure bet for the creator and a sure loss for the sum of all the buyers over time. That is not an investment. No wonder they strive to create more every day.
They are ultimately a sure bet for the creator and a sure loss for the sum of all the buyers over time. That is not an investment. No wonder they strive to create more every day.
Bingo!
Stone Street Adders says ETF's shouldn't be removed from sale while simutaneously showing why ETF's are shite at tracking the Indexes they're actually named after!
You can see the Slipppery Shits' logic here, saying guns are 'good' while simultaneously shooting themselves in the foot with it
How many cars with rubber steering columns can Wall Street produce before the Feds remove these lemons and the lemon growers???
How many pigs ears can Snake Street Advisors excuse and keep plugging as silk purses while trying to prove they perform like Pigs Ear Indexes!
How many people can Shit Street Admonishment call "thick, stupid, naive 5th Graders"... all private investors who don't understand ETF's so far are dumber than mud and now the Wall Street Journal too
...think we've already reached the stage where the whole of society is a stupid 5th grader and the only 'smart' people are the financial snakes and their unapologetic, slightly bitter and twisted, crones... welcome to being a sociopath and their world of Enron accounting, derivitives, MBS's and ETF's
November 21,2008 FAZOpened at 143.40 - Low of 143.00 - High of 201.86 - Closed at 145.25 Down -20.23
The Range on 11/21 was 58.86 points, on 11/24 it was 66.43
The fine print says it was Options Expiration.
NOTE: FAZ doubled in the week before 11/21, and was chopped in half within 2 days afterward.
You think this was crazy, you should see the charts for SKF & SRS.
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November 21,2008 SKF
Opened at 242.92 - Low of 242.24 - High of 303.82 - Closed at 244.12 Down -18.33
The Range on 11/21 was 61.58 points, on 11/24 it was 70.98
The fine print says it was Options Expiration.
NOTE: SKF doubled in a week, and was cut in half 2 days later.
November 21,2008 SRS Opened at 240.27 - Low of 210.41 - High of 295.72 - Closed at 216.67 Down -42.69 The Range on 11/21 was 85.31 points, on 11/24 it was 87.01 The fine print says it was Options Expiration. NOTE: SRS doubled in the week of 11/21, and was cut in HALF on the next trading day! The Plain Facts are:The latter parts of 2008 were volatile in the stock market, as well as many other markets. Large one-day moves and many more intra-days moves became commonplace. It was under these cloudy skies that the gyrations of the thre ETFs FAZ, SKF, & SRS were able to whip around with little attention. Since these are "Inverse" ETFs, their prices were bucking the larger trend: instead of going down like the S&P, they were going up. And being "Leveraged", the degree of their movement was much more than their underlying indexes by 2 or 3 multiples. However, an ETF just doesn't move by itself- its underlying portfolio of stocks' collective pricing is what makes the ETF's prices change. These "Net Asset Values" are calculated throughout the day, at least every 15 seconds. Since each ETF's portfolio contains dozens, hundreds, up to 1,000 different stocks, it would seem that only an ocean tide of market currents would be able to move these ETFS. Not True. In each of these indexes there are a dozen or so of key holdings that account for 30% to 50% of the ETF's "weight", even though they only account for a small portion of the list. Now it should be no surprise that the 3 ETFs mentioned have an overlapping list of top weighted holdings, and these stocks all fell victim to excessive "whack'em & jack'em" on Friday Nov. 21, 2008. Stocks had been falling for most of the 2 weeks prior to the 21st, -200 points on the S&P and by mid-afternoon on Friday, that was enough. Stocks staged a massive rally off the lows of the day and closed higher than the day prior, almost 48 points higher in the S&P, and the range from low to high was much more than that. And so was the range of FAZ, SKF, and SRS. These "stocks" all had ranges that day of 50 points or more, similar to the S&P. But the S&P was priced at $800 a "share" whereas these ETFs were priced between $150 and $300 (much lower). Yes, it was an options expiration day, although it was not necessary to be in options to go on such a wild ride. Matter of fact FAZ didn't even have options trading yet. No, these individual ETFs lived up to their reputation: "Leveraged, Inverse" and WILD on their own. Seatbelts required! IMPORTANT NOTE: The ETFs Mentioned have all had Reverse Splits in the last 3 years, so if you were to look at a chart TODAY you would see prices in the $Thousands /sh and that never happened. Today's historical prices are REVERSE- SPLIT Adjusted (TILPS~SPLIT) Beware.
I feel so important trading etn's like zsl because they send me to the large block desk.
For you reformed leveraged addicts double and triple leveraged etn and etf funds are a nice compromise.
Inverse leveraged EFTs do not mirror the performance of the indices they track. Unless you like losing money, don't use them.
See range on AGQ today 5/2/11? $60 almost ($290.80 low $349.21 high).
And why trade TBT when there's TMV?
The Russell index for FAS/FAZ pair is RIFIN.X.
And no they don't need to be banned, if anything people should/must practice trading them on paper first just to get a good idea of how dangerous they are. Not with real money. They move like quicksilver mixed with lighting mixed in.
vse.marketwatch.com has a nice paper trade platform. It is completely bogus, costs nothing and there are even some games people set up like "Race to a Million" or "Capital Month" where everyone starts with 3k in funny money and see how well they do over a month of trading.
It'll also teach everyone to put in their FUCKING STOPS. Can't stress that enough. Lose a trade fee, not the cash cow.
Thanks for the comment/info. I had the Russell index data but was in a bit of a crunch last night so used XLF in its place since it was in easier format to work with. Will post rifin.x data later if its materially different (I doubt it is, though.)
Completely agree that people should 1. learn how these things trade before actually doing so and 2. practice with paper $ before real $, great idea!
Feel free to practice with this: https://spreadsheets.google.com/ccc?key=0An-C4NLkRQu7dG5hT3YwM010eWl0MlI...
In a one way world, compounding would make you rich. If that way was down, each day diminishes the index by a smaller $/point amount, while expanding the inverse etf. However, in a choppy up & down market, you'll be shredded on both sides.
Boxes in GREEN can be changed to input INDEX, and +etf/-etf 2x/3x Have fun!
Symbol on Google Finance is R1RGSFS
I was wondering what they changed it to. All the <whatever>.X feeds on google were changed along with the group forum settings around 2 years ago.
AND there's a time delay now. Sometimes.