At the beginning of May 2017 the wise, an all knowing Securities &
Exchange Commission approved a new leveraged Exchange Traded Fund. While SEC
approvals for new funds don’t often make headlines, the reason this was did
because of the amount of leverage the new ETF offers and what it means for
the future of investing.
On May 2, 2017, the SEC approved the ForceShares Daily 4x US Markets
Futures Long Fund which will have the ticker “UP” and the ForceShares Daily
4x US Markets Futures Short Fund which will have the ticker “DOWN.”
Yes, you did read that correctly, these are 4X funds which will deliver
400% the daily performance of the S&P 500. Previously investors had
access to 3X funds, which offered 300% the daily moves of the indexes they
track, but with this move, 400% may now seem to be the benchmark.
I have spoken in the past about the dangers of these 3X leveraged funds
and how they can be enticing because of the potential upside, but devastating
because of the potential downside risk. For example, if the market moves 0.5%
one day and you own a 3X long fund, instead of making 0.5% in a day you have
now made 1.5%, a much better one day return. But, the downside risk in my opinion
of even a 3X fund was too great for the average investor because you can
easily lose 3X the amount of money you would normally lose if you had just
bought the standard index fund.
Now that investors have access to 4X returns, yes the gains can be greater,
but the losses will also be larger.
Furthermore, the new 4X products will have the same long-term downsides as
the 3X leveraged funds, but even worse. With a leveraged fund, if you hold
the investment for longer than one day, you are losing money because to get
3X leverage, the fund manager must buy futures which deteriorate, or cost the
investor money, each and every day. If the deterioration rate on a 3X
leverage product was high, I have to imagine the 4X is going to be
substantially larger.
I have never wanted to own a 3X leveraged ETF, so I can assure you the 4X
product is not something I am interested in buying anytime soon. So while
this move by the SEC doesn’t affect me directly, what concerns me about this
move is that it opens the door for possibly a 5X or even 10X leveraged
investment product down the road. Where does this madness end?
The reason this scares me is that the SEC is supposed to product investors,
all investors. Not only from one investor to those trying to sell new
products but also protect one investor from other investors.
While most people know of the 1929 stock market crash, what many forget is
that crash was largely due to the high amount of leverage, mainly through the
use of margin accounts, which were in the market leading up to the time of
the actual crash. Most investors today clearly remember the 2008-09 market
crash which was again largely due to the amount of leverage in the financial
markets at the time of the crash. Leverage is very dangerous and can bring
economies crumbling as we have seen in the past.
Leveraged ETF’s scare me, not because of what I may lose using them, but
how others may affect the overall stability of the market because they are
using these types of products. If we never get more leveraged than 4X, I will
be thrilled, but unfortunately, I feel as if I will be talking about a 5X or
greater product hitting the markets in the future.
