Leverage And Risk

In a 9/23/09 WSJ op-ed, Andy Kessler, a former hedge fund manager, argues against the current administrations proposal to curtail excess bonuses that reward employees of banks and investment firms for taking excessive risks.

Mr. Kessler writes “It wasn’t reckless schemes and excessive risk that sunk banks and Wall Street; it was excessive leverage.” Wall Street investment firms had used that excessive leverage to make what they thought were fairly low risk bets. The complexity of oversight and of rule making to control employee pay makes it difficult to manage.

Kessler’s proposal is a sound one. Instead of a cap on bonuses, Wall Street firms should be charged appropriately for the “insurance” that the Federal Reserve and the FDIC provide Wall Street. That risk adjusted insurance charge will reduce the profit for more leveraged trades, effectively squeezing an employee’s pay on the trade. Kessler argues “let the Fed and the FDIC use to market to protect the market.”

ETF Max

A month ago I wrote about investing in leveraged ETFs, enumerating several risks and the erosion of a investment returns in a see-saw market.

As more brokers recommend these products to their clients as a tool to limit risk or improve returns, the Financial Industry Regulatory Authority (FINRA) is cautioning brokers to exercise some care in how they present these products to their clients.

Leveraged ETFs

In this blog I focus on economic trends and data that will have an impact on our lives, and in a broader way on our investments. As such, I don’t usually go into the particulars of investing in stocks or bonds. However, I will give a word of caution on a particular type of investment – leveraged ETFs. I recently read that some financial advisors are including these in the portfolios of their clients. These products are suitable short term strategies but be cautious before using them as a core holding.

What is a leveraged ETF? For that matter, what is an ETF? It is a basket of stocks, much like a mutual fund, except that it trades like a stock. Typically, one buys an ETF like you would a stock, in whole lot multiples of 100 through a broker. Like stocks, one pays a commission every time one buys or sells.

What is a leveraged ETF? A basket of trading instruments, lets call them, that seeks to either double or triple the return of a particular index of stocks. You can bet with the index or against it. Since ProShares introduced these ETFs a few years ago, they have become quite popular.

The Ultra series of shares seeks to capture 200% of the upward movement of an index. If an index goes up 5%, an Ultra ETF will go up 10%.The UltraShort shares seek to capture 200% of the inverse movement of an index. If an index goes up 5%, an UltraShort ETF will go down 10%.

Sounds simple but, over time, the percentages can work against you. Let’s look at an example. SPY, or Spdr S&P 500, is a popular ETF that is a basket of stocks that closely tracks the movement of the S&P 500, an index that comprises the market weighted prices of the 500 biggest companies in the U.S. I will compare SPY, the PowerShares UltraShort S&P500 (SDS), and the PowerShares Ultra S&P 500 (SSO).

For simplicity sake, I will round to the nearest dollar. On Jan. 5th, 2009, SPY was at $93, SSO was at $28, and SDS was at $67. Fast forward to 3/9/09, a low point in the market not seen in over a decade, when SPY was at $68. That is a 26% decline from the $93 price at the beginning of January. Let’s look at SSO, which should have gone down twice as much as SPY. On that same day, it closed below $15, an approx 48% decline. That is not exactly twice, but close enough. SDS, the short or inverse ETF, should be up twice the 26% loss suffered by SPY, or 52%. On that day, SDS closed at $115, a gain of almost 60%, more than what we expected. If you had bought SDS on Jan. 5th, you would be singing the “greens” on March 9th.

Let’s continue on. The stock market rallied from that low. On this past Friday, SPY was at $89, gaining back all but 2% of what it had lost since Jan. 5th. SSO should be down about twice that, or 4%, but we find that it closed at $24, a 14% decrease from its Jan. 5th price of $28. If SPY has decreased 2% since Jan. 5th, then SDS should be up 4% since then. But SDS closed at $61, a 9% decline from its Jan. 5th price of $67.

What happened? As long as there is a consistent market direction, up or down, these leveraged ETFs work for an investor. If the market seesaws, the percentages work against the investor.

Due to the popularity of 2x leveraged ETFs from PowerShares, a company called Direxion came out with 3x leveraged ETFs late last year.