Have you ever wondered how you can make sure that your portfolio loses money? For those of you who are tired of that extra cash weighing down your pockets and would rather just lose it aimlessly than give it to a worthy cause, I found the ideal investment: levered exchange traded funds.
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Efficient Market Hypothesis
The efficient market hypothesis (EMH) suggests that losing money in the stock market is practically as difficult as turning a profit. Since securities are correctly priced, with arbitrageurs quick to pounce on observable fundamental valuation deviations, market equilibrium is established at an efficient level. Extremely risky investments, such as shares of American Insurance Group (NYSE: AIG) which could inevitably file for bankruptcy protection or require another government bailout are priced according to their underlying risk. Potential dangers facing an investment opportunity are usually factored into the price of the investment. However, levered ETFs seem to defy Eugene Fama's EMH and are a near certain strategy to lose money in the financial markets.
Some ETFs to Keep An Eye On
ETFs such as Direxion Daily Technology Bear 3X Shares (NYSE: TYP), Direxion Daily Technology Bull 3X Shares (NYSE: TYH), Ultra QQQ ProShares (NYSE: QLD), Rydex 2X S&P Select Sector Energy ETF (NYSE:REA) offer a double or triple daily return of their respective benchmarks. Although the recently introduced Direxion Daily Technology Bull 3X ETF has produced a year to date return of approximately 240%, the key to losing money is holding levered ETFs in your portfolio over a long time horizon.
Losing Money Made Easy
Before exploring the essence of how these instruments work, a brief example should hopefully convince doubtful investors of leveraged ETF potential: BlackRock's iShares Dow Jones US Energy Sector ETF (NYSE: IYE) tracks the general performance of the U.S oil and gas sector. The Proshares Ultra Oil & Gas ETF (DIG) and UltraShort Oil and Gas ETF (NYSE: DUG) are the respective double long and double short for the IYE benchmark. During the 2008 period of massive oil price fluctuations, DUG lost a very respectable 19%, while DIG came over the top with a 69% loss.
Consider a hypothetical stock that is tracked by two double-levered ETFs, one bull, one bear. Since the debt portion of the instrument must consistently be rebalanced to ensure a proper debt-to-equity ratio, the funds track the daily performance of the stock rather than the overall annual percent change. Suppose this stock, with an initial value of $100 experiences a 25% price decline, followed by a 25% increase and then a 6.67% increase to bring its price back up to $100. A double-levered bull ETF would have a terminal value of $85 ($100*1.50*0.50*1.133) while the inverse fund would be worth only $65 ($100*0.50*1.50*0.87). This is, of course, before we factor in the management expense ratio. Essentially, despite the trend in the market, these instruments will lose value due to the daily volatility of the underlying asset.
Professional money managers and institutional investors often utilize these instruments when anticipating immediate massive market movements. However, holding long-term positions in levered ETFs should only appeal to those interested in a losing strategy. (Learn more about leveraged ETFs in Dissecting Leveraged ETF Returns.)
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