It seems that the super-size craze has finally entrenched itself in the financial world. While the fast food industry kicked off the notion of "bigger is better", the same philosophy has migrated to televisions, cars, houses and, finally, financial trading vehicles. The past couple of years have seen the introduction of 2x and now 3x leveraged ETFs. While it can be argued that excessive leverage is what got the markets into their current mess, it has not stopped these leveraged trading vehicles from becoming some of the most popular and actively traded symbols on a daily basis. (For background reading, see Dissecting Leveraged ETFs and Rebound Quickly With Leveraged ETFs.)
What Is an ETF?
An ETF is a portfolio of stocks, bonds or other investment class that trades on a stock exchange, much like a regular stock does. ETFs are essentially index funds in that they track the performance of a specific index or asset. Leveraged ETFs attempt to track the index with borrowed capital in order to increase investment exposure. The fund will typically be levered by a factor of two or three for every dollar of investor capital. However, it is important to note that these levered ETFs attempt to mirror the daily rate of change for an index. They then reset each night and attempt to repeat this feat each day. For instance, if the Russell 2000 trades up 1% for the day, the 2x tracking ETF will attempt to match that with a factor of two, or 2%. The 3x version would follow at 3%. The farther out in time you go, the less correlated the returns will be.
However, with the additional leverage comes additional risk. If traders are not careful, they could find themselves in a world of pain. A common mistake with some traders is trading a leveraged ETF with margin. This can exacerbate what is already a volatile trading vehicle into a surefire margin call. With the increased volatility of the current market, it is not uncommon to see a daily move in excess of 20-30%; if a trader is leveraged at 2x in his margin account, it could really lead to unintended consequences in a hurry.
Currently, the most popular leveraged ETFs revolve around the financial sector. While each of these ETFs tracks a specific - and not necessarily correlated - index, the indexes tend to move in concert with each other. The Financial Select Sector SPDR Fund (NYSE:XLF) for instance, seeks to closely match the returns and characteristics of the Financial Select Sector Index. This fund does not use leverage and is a widely used proxy for trading the financial sector.
The ProShares Ultra Financials Pro fund (NYSE:UYG) seeks daily investment results, before fees and expenses, that correspond to twice (200%) the daily performance of the Dow Jones U.S. Financials Index. Even though it tracks a different Index altogether from XLF, the two tend to move in unison, with moves in UYG magnified at 2x. If using twice the leverage is not enough for you, then the Direxion Financial Bull 3x Shares (NYSE:FAS) is your super-sized ticket into the leveraged ETF world. FAS seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 1000 Financial Services Index. The chart below illustrates exactly how pronounced the moves in a leveraged ETF can be in the current market environment.
XLF has fallen 43% since the beginning of 2009. UYG has fallen almost 68% in the same time. While this doesn't translate to twice the move in XLF, keep in mind they track different indexes. FAS, in the meantime, has fallen an incredible 84% the past two months. This is why it's important to size a position in a leveraged ETF accordingly. A trader holding FAS on margin would surely have gone broke over the past couple of months.
In addition to leveraged ETFs, there has been a recent explosion in inverse ETFs. As the name implies, these ETFs seek to match the opposite return of the instrument they track. This offers a convenient way for traders to hedge their portfolios or enter short positions in accounts that would otherwise restrict short positions. In addition, for every leveraged ETF, there is usually a matching inverse leveraged ETF. (For more insight, read Inverse ETFs Can Lift A Falling Portfolio.)
For instance, the UltraShort Financials ProShares Fund (NYSE:SKF) seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Financials Index. This is exactly the opposite of UYG as both are intended to complement each other. The Direxion Financial Bear 3x Shares (NYSE:FAZ) is the complement to FAS and is up a whopping 108% so far this year. It's interesting that even though FAS and FAZ complement each other, they are not perfect mirror images of each other. There are no guarantees that these ETFs will meet their specified objective on any given day, which has a compounding effect longer term.
The following chart shows the performance of the Short Financials ProShares Fund (NYSE:SEF) and the leveraged inverse ETFs mentioned above.
While SEF has returned 45% since the beginning of the year, SKF and FAZ have gained 93% and 108% respectively. These are super-sized gains for any trader actively participating in these ETFs. They also show how using these products as a hedge for any financial holdings could have softened the blow or even led to profitability despite weakness in the sector.
Leveraged ETFs are useful and powerful trading vehicles that can add value to any trader's arsenal. However, just like we shouldn't be abusing super-sized fast food, traders need to be aware of the dangers associated with over leveraging their accounts. For further reading, see The Joys And Pains Of 3X Returns.
At the time of writing Joey Fundora did not own shares in any of the companies mentioned in this article.