THE BOTTOM LINE ON LEVERAGED ETFs
I have received a bunch of emails over the past 24 hours with respect to leveraged ETFs following the ZeroHedge article on FAZ. This is actually an article I have been wanting to post for awhile, just haven't gotten around to it. The Zerohedge article seems like a good opportunity to address the issue of leveraged ETFs.
The answer to the question of whether leveraged ETFs are bogus, frauds or just money sucking vampires is very simple to address. They are as much bogus, a fraud or money sucking vampires as option contracts are. In fact, leveraged ETFs should not be classified with the "ETF" label. These are not ETFs. They are essentially derivative contracts that employ varying degrees of leverage.
Much like a steroid user in the bodybuilding world, you don't get the benefits of looking superhuman without the drawbacks that come with it. If you don't manage the drawbacks of anything that boosts performance, then it can ruin you.
Leverage is much the same way. There is no such thing as "free leverage" on Wall Street. You pay the price for the potential performance in the form of deterioration of that particular asset should the market not go the direction you had planned. In fact, the deterioration still occurs if the market takes it time in eventually making the move you expected. Much like options, in order to get the maximum potential out of a leveraged ETF, your timing needs to be correct. These are not invest and forget securities.
That is exactly why I look at my investments in issues such as FAZ, TZA and EDC as option contracts. I look at them as deteriorating assets within the portfolio that need to be managed appropriately and are not meant to be held for more than one month.
I prefer to use leveraged ETFs as opposed to option contracts because the deterioration should I be wrong about a particular trading idea is not nearly as great as an options contract.
For traders who know how to manage their risk appropriately, securities such as FAZ can be great tools for maximizing your gains. As long as you realize what these securities are and what they aren't. If you are the type that takes a look at FAZ and makes pie in the sky calculations of how much money you will make when Bank of America begins trading on the pink sheets, odds are that you will be terribly disappointed.
I believe that in 2012 these "ETFs" will be reclassified and see more regulation. I don't expect them to be removed from the market as they do have a place. Much like when option contracts began trading, leveraged ETFs are being greeted with suspicion and doubt as to their validity in the current marketplace. Any regulation will probably come in the form of signing documents and educating investors with respect to the pitfalls of these investments, much like option traders must do before opening accounts.
Investors need to stop looking at these instruments as ETFs and begin looking at them for what they are: deteriorating derivative contracts that should be traded and managed as such.
