Caution: Beware of These Popular Investments

Exchange-traded funds (ETFs) are coming under more and more scrutiny by investors and the government lately.

And who can blame them? With over $1 trillion – almost 10% of the valuation of the U.S. stock market – socked away in ETFs, they make an attractive target.

After all, they’re far superior to similarly constructed mutual funds. They cost less in management fees and they’re even tradable during market hours.

But it’s important to remember – not all ETFs are created equally.

There’s absolutely nothing wrong with an ETF that mimics a basket of stocks, bonds, or commodities.

[ad#Google Adsense 336×280-IA]For example, gold ETFs give investors a fantastic alternative to buying the physical asset itself.

My concern is with leveraged ETFs.
You see, they can do some serious harm to investors who are misinformed or uninformed about how they work.

And the reason these leveraged instruments will soon face increased scrutiny is because of the danger they pose to the market in general. Especially when they’re used in a way that “creates” an event rather than only participating in one.

Let me explain…

The Hidden Dangers of Leveraged ETFs

Albert Einstein once said, “The most powerful force in the universe is compound interest.”

But with leveraged ETFs, you’re missing this critical ingredient to long-term success.

Basically, leveraged ETFs work by betting on moves in an underlying investment by a factor of two or three times. But they reset daily.

In other words, the closing price of the previous day means nothing going forward.

Say you have a double short S&P 500 ETF and the market falls 5%. You would earn 10%. If it falls 5% the next day, you would earn another 10%, and so forth.

That’s great, but you’re not compounding or “building” gains.

Had leveraged ETFs actually been constructed to benefit from compounding, you could simply buy a triple long ETF and a triple short ETF – in equal amounts – and win every time.

For example, say you invested $20,000 in each…

Well, the most you can lose on one side would be $20,000. But the most you can make on the other side would be infinite.

If the market went up 100%, one would triple in value while the other could (and would) only lose the initial amount.

You can’t lose 300% of what you invested!

The reality is, these ETFs don’t mimic the market’s movement over a significant period of time, just over a very short span.

Take a look at the telling chart below:

Had you bought EITHER a double long ETF on the S&P 500 or a double short ETF on the S&P 500 back in 2006, you’d be a net LOSER right now.

It’s a serious enough situation that the Securities and Exchange Commission has posted a warning on its website. (I encourage you to check it out.)

But it’s what these leveraged ETFs are actually investing in that has me worried the most…

ETF Manipulators Are Causing Wild Swings

You see, all these double and triple ETFs must invest in something to make the gains. And that “something” is futures and options contracts.

Think about it… It’s the only way to make outsized gains in one direction.

By doing so, these ETFs do affect volatility in the market.

If some hedge fund manager wanted to see the market move lower, he could just pile into a triple short ETF.

That ETF would then have to make a triple short bet in the market by buying put options on the underlying instrument.

Moving that amount of volume into put contracts could easily send the volatility of the underlying instrument soaring, thereby creating a panic.

Any hedge fund employing such a strategy would know the risk upfront. In fact, it could multiply the volatility by buying options on the ETF. And why not? Its risk would be limited to the premium invested.

If a hedge fund wanted to “short” the market the old-fashioned way, it would have to either buy regular put options or short the index itself.

But buying regular put options would require much more risk capital to engineer than a three-times leveraged ETF. And shorting a stock or index would only open the door to massive capital losses.

That’s why these wild swings we’re seeing in the market – especially in specific sectors – could be due to this manipulation of short and long leveraged ETFs.

I say this simply because it allows the guilty parties to achieve a goal in a very short period of time and for very low cost – something that many hedge funds and trading desks find irresistible… for now.

Ahead of the tape,

— Karim Rahemtulla

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Source:  Wall Street Daily