Do not use a Leveraged ETF for Hedging

by Manshu on January 15, 2009

in ETF

When I read about a – Leveraged ETF, for the first time – I wondered – who will be interested in such a product?

Leveraged ETF is: too fancy a product for long-term investors, or even other ordinary investors. I think a person who can be interested in an ETF, that is good, only, for a day (and understand that fact) should be sophisticated enough to buy derivative options himself, and create a similar product. This will save a lot of costs, and will certainly be a lot more exciting, than simply buying an ETF.

Hedging with a Leveraged ETF

Then I came across this interesting question in The Dividend Guy’s website – Could you hold 75% of your portfolio in stocks, and buy 3X Leverage Funds that short the market?

So, theoretically, you have 3/4th of your portfolio in common stocks, and 1/4th of your portfolio is invested in a product that shorts the market 3 times.

While, the idea itself is good, the daily nature of Leveraged ETFs do not allow them to be the right tool to execute this strategy.

A Leveraged ETF uses daily leverage and that is what makes all the difference – Daily Leverage. Let me take an example of how this would work:

Suppose, we have an Index and it moves in the following manner:

Day 1, Index Value – 1000

Day 2, Index Value – 1050 (Gain of 5%)

Day 3, Index Value – 1000 (Loss of 4.76%)

An ordinary ETF will give you no profit, no loss – in such a situation.

However a Leveraged ETF, that  needs to lever itself every day will move in a different manner. A 3X fund will gain 15% on the first day, and then lose 14.28% (4.76 x 3) in the second day.

Here is how it will look:

Day 1, Index Fund – 1000

Day 2, Gain of 15% on 1000    – 1150

Day 3, Loss of 14.28% of 1150 – 985.78

So, even though the market didn’t move at all – you stand to lose money on your investment.

When looked at it from a Hedging perspective – your portfolio of stocks has netted you no gain, but, your Leveraged ETF has caused you a loss.

That makes this product really bad for hedging. Unless, of course – you have the time and ability to counter the daily leverage, and balance your ETF investment daily.

What else can you do with a Leveraged ETF?

You can lose a lot of money.

This product is not for any investor – who wants to hold their money in a derivative instrument for more than a week.

I share the same skepticism as Invest Skeptically, when it comes to this new product. The fee is high, tracking error should be high (although I don’t have data on this), it is a leveraged product – so there is a risk that the counter – party will default, and it is too complicated a financial product; to execute it successfully, and without losing a lot of money.

{ 3 comments… read them below or add one }

The Dividend Guy January 18, 2009 at 4:48 am

Thanks for the link back and good article – shows how quickly you can go in the hole with a strategy like this.

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manshuv January 18, 2009 at 7:57 am

The Dividend Guy,

Thanks for visiting and commenting. I always try and stay away from shiny, new and complicated products that are hard to understand. The risks outweigh everything else.

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Lawn March 22, 2009 at 1:04 pm

Great quality stuff.

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