Friday, January 2, 2009

Leveraged ETFs (stock)

I am one of those who believe that leveraged ETFs (especially those on the short side) and other leveraged derivative instruments played a major role in how quickly and how hard the market has come down. My contention is that these side bets have become the main pot, as mentioned in this post from November:

While looking online, I have come across this interesting comment which I think shows a great example of one of the things wrong with these instruments. It's by user 325353 on this page:
I have read the whole page but I will just copy and paste a big chunk of the comment here.

"...these are terrible vehicles... ...because of their design. Lets take a look at a real world example: SRS is the UltraShort Real Estate ETF, it "seeks daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Real Estate Index." The ticker for this Dow Jones U.S. Real Estate Index is IYR. Lets see how they've done this year... IYR is down 43% year to date (so SRS should be up 86%?? WRONG), SRS is down 43.6% year to date! The reason is the design of the vehicle, SRS moves 2x in the inverse of IYRs daily percentage change. Easy example (extreme example but should open your eyes): lets say IYR rallies from last nights close of ~35 to 52 on today's trading, up 17 points or ~48.5%. SRS will be down 97%, having closed last night at ~57, that will put its close today at 1.71. Now lets say the next trading day IYR takes it on the chin and closes at 20, setting a new all time low (its 52 week low was 23.51, when SRS was up near 300), that makes IYR down 32 points or ~61.5%. Wheres that put SRS?? not 300! SRS will be up 123% from the 1.71 close to end trading at 2.10. Nice Trade. In 2 days time IYR has gone from 35 to 20, down ~43% and SRS has gone from 57 to 2.10, down over 96%. The problem with these twice levered ETFs is that is not just a twice levered bet on a short, they're are higher order risks brought into the equation. Its not only a bet on where the underlying instrument goes but also a bet on the path it takes to get there. These ETFs are not doing "exactly what they're intended to do" and there's no way the average investor out there is taking these risks into account before jumping in and getting smoked on technicals. These machines deserved to be raged on, not for their intent but rather for their design."

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