One change made fools of the Securities and Exchange Commission ("SEC")...
Up until 2019, the SEC reviewed every exchange-traded fund ("ETF") that came to market. These funds allow investors to own baskets of stocks.
Part of the SEC's job was to make sure each new fund wouldn't harm buyers. But this took time and resources. So a rule was imposed to streamline the process. It approved certain funds without the SEC's permission.
The change made sense – at least in theory. Then, this July, an array of "single stock" ETFs slammed through the loophole.
SEC Commissioner Caroline Crenshaw issued a statement just before the funds debuted...
I am disappointed... are risky products for investors and potentially for the markets, as well.
Crenshaw is right. Here's why: Single-stock ETFs give exposure to just one company, with leverage.
In other words, your position is multiplied. Your rewards can double, or even triple... But the danger goes up just as much.
Many investors will buy these ETFs thinking they can handle the risk. But they should be wary... and not only because their positions might fall.
You see, leveraged funds can eat into your returns – even when a bet goes your way. Let me explain...
There's low-risk investing, high-risk investing... and then, there's investing with leverage.
Leverage is just about as risky as it gets. It's when you take on debt to buy even more of a given asset. You get a multiplier on your returns. But your potential loss multiplies too.
That doesn't stop folks from trying to use it. In the last three months, four of the five most-traded ETFs were leveraged. Their multipliers range from 1.5 times to 3 times performance.
The danger of bigger losses might seem obvious here. But there's another catch in the fine print, and it's critical to understand.
These ETFs don't offer a long-term multiplier on the underlying fund or stock... They offer a multiplier on price action for the day.
The funds reset every morning – and that can spell trouble in the long term. Here's an example...
Let's say that on Monday, a single stock and its twice-leveraged ETF both open at $100. By the end of the day, the stock falls 10% for a $10 loss. The ETF doubles that loss and falls $20.
Now the stock is worth $90, and the ETF is worth $80.
On Tuesday, the stock goes on a tear. It rises 10% – a gain of $9. The ETF doubles that, soaring 20%. Because it started the day at $80, the ETF's gain is $16.
So the stock closes at $99, down just 1% from where it started. Meanwhile, the ETF closes at $96. With double leverage, you might have assumed you'd be down 2% on the ETF... But instead, you're down 4%.
The ETF reset at a lower basis on day two, so its upside potential fell. That's the problem with leveraged funds... They decay with every drawdown.
When markets turn sideways or bearish, the decay really adds up. And the longer you hold leveraged funds, the more likely it is that you'll underperform.
I don't recommend using leverage in your investments. Good risk management is key to growing your wealth... And leveraged funds add a lot of volatility to your portfolio.
But if you insist on using leverage, make sure you understand the risks. Have a system... And don't own them for long.
Otherwise, your returns may be a lot lower than you bargained for.
Sean Michael Cummings
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