Leveraged ETFs aren’t for most of us
Investors are cheering the fact that President Donald Trump’s election elevated animal spirits on Wall Street, giving new life to an aging bull market.
Those same animal spirits — and chronically low interest rates — have given rise to all sorts of “risk on” propositions, including two new investment vehicles approved by the U.S. Securities and Exchange Commission last week.
ForceShares Daily 4X US Market Futures Long and Short funds are similar to other exchangetraded funds that seek to generate returns that are multiples of the daily return on S&P 500 futures contracts. Except the new funds are on a higher dose of steroids.
“I worry about stuff like this,” University of Pittsburgh finance professor Jay Sukits said. “This is like fooling around playing Russian roulette.”
Exchange-traded funds, or ETFs, can be perfectly fine investments built around baskets of stocks or bonds that provide investors with convenient, low-cost exposure to the broad market. Assets in ETFs totaled $2.8 trillion in March, up 29 percent from a year ago, according to the Investment Company Institute, an industry group.
ForceShares’ offerings do not fit that bill. They are leveraged ETFs — using investor money, borrowed funds and derivative investments in their search for returns greater than those offered by futures contracts covering the S&P 500.
There are two flavors of leveraged ETFs. Long funds seek to generate returns that are multiples of the index they are tracking. Inverse ETFs seek returns that are multiples of the exact opposite of how an index performs on any given day. An inverse ETF targeting three times the return will go up 3 percent if the index goes down 1 percent.
Leveraged ETFs offering returns two or three times greater than what their target index generates daily have been around for a while. What’s raising the eyebrows of some about the ForceShares offerings is that they are targeting returns four times the daily performance of the S&P 500 futures market.
Critics claim the complex investments serve little purpose other than as a hedge for sophisticated investors who understand them or for those gifted people who are convinced they know how the market will perform on any given day.
“These products are designed for highly specialized people or day traders. They’re not meant for you or me,” Carnegie Mellon University finance professor Lars Kuehn said.
For everyone else, they are risky business.
“They should probably come with a warning on the side of the package like cigarettes do,” Mr. Sukits said.
A look at the ForceShares
funds’ registration statement provides enough information for investors to conclude they shouldn’t try this at home.
The filing contains 21 pages of risk disclosures. A lot of the verbiage is the standard boilerplate you’ll find for other investments. There also are disclosures of what some investors already know: that if you hold a leveraged ETF for longer than a day, the performance can differ significantly from the returns advertised. Just because the targeted index goes up 1 percent over 20 days doesn’t mean an investor will realize returns that are two, three or four times greater. They could experience a loss depending on how the market gyrated from day to day over that period.
“I would never say it’s a good investment for a long-term investor,” Mr. Kuehn said.
There are more problematic disclosures.
“The sponsor is recently formed, and has not previously managed any commodity pools. The operation and performance of the funds may be adversely affected by this lack of experience,” reads one.
There are also some warnings about the sponsor’s “limited funds,” its office being “leanly staffed,” and how “an unanticipated number of redemption requests during a short period of time could have an adverse effect.”
The disclosures weren’t enough to stop the SEC from giving the leveraged funds clearance. But they provide a very clear idea of what could go wrong, as things invariably do in markets.
Moreover, there’s every reason to believe that the funds will appeal to those beyond their intended audience, to the greedy and ignorant who are guided solely by animal spirits. It’s the free market’s finest hour.