At the beginning of May 2017 the wise, an all knowing Securities & Exchange Commission approved a new leveraged Exchange Traded Fund. While SEC approvals for new funds don’t often make headlines, the reason this was did because of the amount of leverage the new ETF offers and what it means for the future of investing.
On May 2, 2017, the SEC approved the ForceShares Daily 4x US Markets Futures Long Fund which will have the ticker "UP" and the ForceShares Daily 4x US Markets Futures Short Fund which will have the ticker "DOWN."
Yes, you did read that correctly, these are 4X funds which will deliver 400% the daily performance of the S&P 500. Previously investors had access to 3X funds, which offered 300% the daily moves of the indexes they track, but with this move, 400% may now seem to be the benchmark.
I have spoken in the past about the dangers of these 3X leveraged funds and how they can be enticing because of the potential upside, but devastating because of the potential downside risk. For example, if the market moves 0.5% one day and you own a 3X long fund, instead of making 0.5% in a day you have now made 1.5%, a much better one day return. But, the downside risk in my opinion of even a 3X fund was too great for the average investor because you can easily lose 3X the amount of money you would normally lose if you had just bought the standard index fund.
Now that investors have access to 4X returns, yes the gains can be greater, but the losses will also be larger.
Furthermore, the new 4X products will have the same long-term downsides as the 3X leveraged funds, but even worse. With a leveraged fund, if you hold the investment for longer than one day, you are losing money because to get 3X leverage, the fund manager must buy futures which deteriorate, or cost the investor money, each and every day. If the deterioration rate on a 3X leverage product was high, I have to imagine the 4X is going to be substantially larger.
I have never wanted to own a 3X leveraged ETF, so I can assure you the 4X product is not something I am interested in buying anytime soon. So while this move by the SEC doesn’t affect me directly, what concerns me about this move is that it opens the door for possibly a 5X or even 10X leveraged investment product down the road. Where does this madness end?
The reason this scares me is that the SEC is supposed to product investors, all investors. Not only from one investor to those trying to sell new products but also protect one investor from other investors.
While most people know of the 1929 stock market crash, what many forget is that crash was largely due to the high amount of leverage, mainly through the use of margin accounts, which were in the market leading up to the time of the actual crash. Most investors today clearly remember the 2008-09 market crash which was again largely due to the amount of leverage in the financial markets at the time of the crash. Leverage is very dangerous and can bring economies crumbling as we have seen in the past.
Leveraged ETF's scare me, not because of what I may lose using them, but how others may affect the overall stability of the market because they are using these types of products. If we never get more leveraged than 4X, I will be thrilled, but unfortunately, I feel as if I will be talking about a 5X or greater product hitting the markets in the future.
Disclosure: This contributor held long positions in Apple, Tesla, Intel, Google, Amazon.com, Facebook, Priceline and Microsoft at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.