Leverage Is a Tool to Be Used Only When Understood

Last week Trevor Hunnicutt reported in ETF.com’s daily posting that the SEC approved quadruple-leveraged ETFs. This is the first time 4x leverage has been approved for use in ETFs in the United States. Leverage is used in many ways in financial transactions. In the structure of domestic mutual fund products, leverage available to the public until now has been limited to 3 to 1 (3x leverage).

Let’s start with a brief discussion about leverage. Leverage in the financial markets is the use of borrowed funds or structured contracts, such as options and futures, to gain access to exposure to a market beyond what actual cash may be put up. Examples of the use of leverage include people putting money down and getting a loan to buy a house, a business doing the same thing to build a plant, and an airline putting money down as a good-faith deposit on a futures contract covering the fuel they will need in December. In all of these examples, leverage was used to magnify the purchasing power of the amount of money put down on the transaction. Leverage is not inherently a bad thing. It is a financial tool widely used by individuals, businesses, and governments. It can be used wisely and unwisely.

Mutual funds (including ETFs) are generally not allowed to borrow money to buy securities, even though doing so is a common practice in the financial industry. Many years ago funds were allowed to use options and futures within their portfolios to manage risk and to gain exposure to stocks and bonds without committing all of their available cash. This set the stage for what are known as leveraged funds.

Anytime leverage is used to magnify exposure to securities, it does so both in up market moves as well as down. An ETF that uses 2x leverage magnifies each dollar in the ETF by a factor of 2, and so on for 3x and 4x ETFs. The following graph illustrates a $10,000 investment in a 1x, 2x, and 3x S&P 500 ETF over the past five years. Notice that both the rising and falling moves are magnified by a factor directly related to the leverage used by the ETF. A 4x ETF is not illustrated because it does not currently exist in domestic markets.

$10,000 investment in a 1x, 2x, and 3x S&P 500 ETF , Invest With An Edge

The following table shows the effect of leverage. The exposure, gain, and loss values all assume the purchase of $10,000 of S&P 500–based ETFs using different amounts of leverage.

Effect of Leverage, Invest With An Edge

In crafting portfolios of securities such as ETFs, investors use leverage for many reasons. For example, investors may want to increase the efficiency of the use of capital, increase exposure when they aren’t able to borrow money on margin (as is the case in retirement accounts), or add volatility when the market is not providing it.

Let’s take the efficiency of the use of capital as an example. An investor who wants $30,000 of exposure to the S&P 500 could buy $10,000 of a 3x S&P 500 ETF and $20,000 of a short-term bond fund and earn a bit of interest on the bonds in addition to getting the desired exposure to the S&P 500. Many investment strategies require certain levels of market volatility in order to drive meaningful returns. Sometimes the market provides adequate volatility. However, when it does not, volatility may be added to a strategy by using leverage. A convenient way to do this is through the use of leveraged ETFs. For retirement accounts that cannot borrow money, it is one of the only ways to employ leverage.

Leverage has been used in economies ever since there were borrowers and lenders. Leverage in the securities industry is readily available and often used. Leverage is able to be carefully tailored to nearly any investment style and methodology. According to the 2017 “ETF Field Guide,” there are 127 ETFs that use (long) leverage. The following table shows how that total breaks down by investment category.

total breaks down by investment category, Invest With An Edge

Use leverage with a purpose and an understanding of both the benefits and risks. Leverage should not be used simply because it is available. In other words, leverage in financial markets should be used with the same knowledge and care as leverage provided by credit in our day-to-day lives.

Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.

The Economy as Seen Through ETF Relative Strength

Last week I mentioned that longer-term trends in leadership tend to be based on macro factors such as economic trends and changes in political leadership or policies. The change in leaders and laggards among the ranking of our Sector Benchmark ETFs and our Factor Benchmark ETFs tell us a good bit about changes that may be coming in the domestic economy. For example, this week there were only minor rank changes. This suggests that, despite the usual avalanche of news, investors see few developments that would change their relatively optimistic expectations for the economy. In general, the lagging sectors appear to be there because they are perceived to be unnecessarily defensive or are special situations.

There were only minor rank changes in sectors and factors, but the tables offer more to the story. There was an overall reduction of momentum in most sectors and factors. This suggests that investors, at least domestically, were not inspired to make changes in their view of markets, nor were they inspired to commit meaningful new capital to their positions. However, the story is different among our Global Edge Benchmark ETFs. That is where the action was seen this past week.

Sectors: The leading Sector Benchmark ETFs for the past several weeks suggest that the economy is growing and expected to continue to grow. Investors continue to favor Technology and Discretionary. This week Health Care moved into the #3 slot, replacing Industrials. Investors are not concerned about the immediate prospects for sectors benefiting the most from a growing economy. It is fitting, then, that investors have a diminished appetite for Real Estate, Telecom, and Energy. These lagging sectors may be explained more by special situations than by economic expectations. Rising interest rates may be taking the glow off Real Estate, price wars are affecting Telecom earnings, and an oil glut is holding down energy prices. The leaders and laggards have not changed much in recent weeks, which is a sign that the news (real or fake) has done little to change investors’ near-term or long-term expectations. Put another way, there has been little to raise investors’ near-term or long-term investing-related fears.

Factors: Momentum and Growth are the top factors among our Factor Benchmark ETFs again for the week. This is very much in line with the sector rankings and what they say about investor expectations. This alignment of rank reinforces the view that investors have of the market and the economy. This is important insight because investors tend to invest with a view of the future rather than recognition of the past or present. This means that the economic growth that investors are positioning their money for is growth they expect in the future, not growth we have already experienced. When investors become concerned about future economic growth, we will see our rank order change significantly as investors seek defensive, rather than offensive, sectors and factors.

Global: There was a lot of activity among the Global Benchmark ETFs. There large changes in rank and also in the overall level of momentum among all of our Global Benchmark ETFs. There were some interesting changes this week: The weakest global regions are USA, Japan, Pacific x-Japan, and Canada. The top-ranked regions include Eurozone, China, and Emerging Markets. This ranking can most likely be attributed to investors’ long-term underweighting of those regions that are now leading the rankings. Conversely, they favored the regions that are now lagging. Therefore, this ranking may not reflect a belief that the leading regions will have the best economies going forward, but that those economies are not now in danger and therefore it is acceptable to weight them more normally in a global portfolio.

Also interesting is that 6 of the 11 leading Global Benchmark ETFs have momentum scores above 20. This is noteworthy because only one sector and two factors have momentum rankings greater than 20. So, the action is clearly in the Global Benchmark ETFs this week.

The following Edge Charts are market momentum snapshots. They provide a quick and easy way to help you visually get a handle on the overall state of the market. With these charts, you can assess both the relative strength and absolute strength (momentum) of more than 30 global equity market segments. Please refer to the Edge Chart User’s Guide for further explanation.

Weekly Edge 051717, Sector Edge, Factor Edge, Global Edge, Invest With An Edge

Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.

“Sometimes the best stories in ETF land are the ones that go unnoticed. Sure, one hiccup occurs somewhere in the system and we see headlines for weeks. But most of the time, ETFs do incredible, extraordinary things, and nobody notices.”

—Dave Nadig, ETF.com, May 12, 2017

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