6 Leveraged ETF Rules Hedge Funds Use

06/13/2012 8:30 am EST

Focus: ETFs

Leveraged ETFs offer benefits never before available to retail traders, writes William Meade of Minyanville.com and Global Investor Monthly, who shares six rules for trading them as safely and cost effectively as the pros.

As a former hedge fund trader and the head of ETF research for a major investment research firm, I have never been more excited about the trading opportunities that are available in leveraged ETFs.

This is the first time in financial history that the retail investor has the same investment tools that hedge fund managers have been using for years to produce huge market-beating returns regardless of market conditions.

The reason retail investors are constantly losing, especially in today’s market conditions, is because they are too one dimensional. For the most part, they invest in traditional stocks and bonds, and they do so through mutual funds or individual stocks or bonds.

In a hyper-competitive investment climate, this dramatically limits their ability to be compensated for the risks that they take. This economic environment has exposed that fact.

Hedge fund managers, however, don’t have these restraints. They can invest in any asset class: stocks, bonds, commodities, currencies, private equity, real estate, etc. Moreover, they also have the ability to go short, which is a key advantage that you won’t find in a passive, asset-gathering mutual fund.

It’s this flexibility that is crucial to investing success, as we have seen in recent years with the unprecedented volatility and bear markets that have devastated long-only stock investors.

Invest Like a Hedge Fund Pro With Leveraged ETFs

Leveraged ETFs give the investor the unique ability to invest globally, to invest with leverage, and to take advantage of both up and down markets.

In essence, the average investor can now create their own custom, absolute return, long-short global macro strategy, and they don’t have to be a millionaire or pay chunky minimum investments and high fees to get it.

Absolute return means that in any market condition—bull markets, bear markets, or sideways markets—you can always pursue positive returns. You aren’t a slave to the broad market indices!

Billionaire global macro investor Stanley Druckenmiller was a pioneer in absolute return, long-short strategies. He used leverage and the ability to go long and short to produce one of the greatest track records in history: 30% annualized returns over 30 years, without one single losing year.

See also: Trade Down Moves without Going Short

Like Druckenmiller did for years, now the average investor can take leveraged positions long or short in the S&P 500, Nasdaq 100, emerging markets, gold, oil, Treasury bonds, currencies, and equity sectors such as financial, technology, and energy…just to name a few.

These securities are maturing nicely, and the liquidity in leveraged ETFs is becoming very deep. These specialty ETFs trade well over ten million shares per day, with some trading over 40 million shares.

This is important: it means the bid/ask (or the spread to pay to enter and exit a trade) has narrowed to almost nothing—pennies or less than a quarter of 1%—to buy or sell these leveraged ETFs, making them an incredibly cost effective way to trade.

Also advantageous, leveraged ETFs can be traded in a variety of accounts such as IRAs, and unlike futures, these securities won’t expose you to unnecessary broker risk.

Not only is it burdensome to open up a futures account, but it is also dangerous, as we have seen from the collapse of MF Global and Refco, which literally lost investors’ entire accounts when they collapsed. Futures accounts have margin requirements as well, while ETFs do not.

Plus, leveraged ETFs are SEC-registered products that are relatively simple and easy to use.

Why Aren’t More People Trading Leveraged ETFs?

Well, part of it I blame on misinformation. Many advisors, and the financial press, have called these products dangerous, expensive, and/or flawed because of tracking error issues. All of this is blown out of proportion, in my opinion. Properly using techniques like stop losses and properly reading charts will help the investor control the risk of these products.

See also: The Hidden Danger in Some ETFs

Secondly, these products are only expensive if you buy and hold, which you should never do with leveraged ETFs. These are trading vehicles, not ones to hang on to.

The average expense ratio on a leveraged ETF is 1.25% per year, but when trading these products with holding periods of days or months, you barely incur any fee at all. For example, if you hold a leveraged ETF that has a 1.25% management fee, you would incur a fee of .125%, or one-twelfth of 1%; not a very high fee. Most people pay this or more every day when then buy or sell as stock with the bid/ask spread.

Moreover, leveraged ETFs are actually the cheapest way to short. When you short a stock, you have borrowing costs and margin costs. When shorting with leveraged ETFs, you have no borrowing costs and no margin cost.

Third, many financial pundits have said that these products don’t do a great job of tracking the underlying index they trade. That is not accurate. Of course, there will be times when leveraged ETFs do not perfectly track their benchmark, but it’s only for a very short period of time, and it is such a small amount that it isn’t even noticeable.

I have been trading these products for over three years, and I will tell you that the biggest tracking error or difference between the leveraged ETFs benchmark and the leveraged ETF is around .25%, or a quarter of 1%; again, a very negligible amount. Plus, the more liquid the ETF, the lower the tracking error. Next, however, I will tell you how to get around the tracking issues.

NEXT: 6 Rules for Trading Leveraged ETFs


6 Rules for Trading Leveraged ETFs

Here is a list of rules and guidelines that I have compiled throughout my experience trading and researching leveraged ETFs. I have been researching and analyzing leveraged ETFs for over four years since their inception first as the director of ETF Research for Zacks Investment Research and currently in my hedge fund, Leveraged ETF Capital.

  1. Liquidity and Volume Are Key: This is probably the most important rule. Only trade leveraged ETFs that are liquid, and that have an average daily volume over 100,000 shares. This is important because you are assured of getting a tight bid/ask or spread, meaning it costs you less to buy the ETF. A liquid market ensures that you can buy or sell at any time.
  2. Never Buy and Hold Leveraged ETFs: My holding period is anywhere from one day to six weeks. By following this guideline, you will never have to pay the full management fee for these products, which will keep your costs low.
  3. Always Use Stop Losses: Leveraged ETFs are volatile and can offer huge double- and triple-digit returns in a very short period of time. However, to make sure you never lose a lot of your trading capital, you must use a stop loss.

    This doesn’t mean using a mental stop loss or telling yourself, "I am going to sell when it crosses XYZ price." It means that every single time you buy a leveraged ETF, place a stop loss with your trade. This assures that your loss will be minimal. I cannot reinforce this practice enough: Always, always place a stop loss with every single leveraged ETF trade.
  4. Trade off the Benchmark Chart, Not the ETF Chart: If you’re using technical analysis (which I suggest doing with these investment products because they are trading vehicles), always use the actual benchmark’s chart to generate trading signals. Do not use the chart of the leveraged ETF.

    This means that if you want to use a leveraged ETF to trade oil or gas, use the actual spot price of oil chart or the spot price of gold chart to generate your trading signals. These charts are more reliable and better indicators of the sentiment of the market than the actual ETFs.

    For example, if I looking at a chart of the Nasdaq 100 Index, and it looks like it is technically breaking down and I want to short the Nasdaq, I will wait for a break on the actual Nasdaq 100 chart to make my trade, and then buy the inverse (or short Nasdaq 100) ETF to make my trade; I will not use the chart of the inverse Nasdaq leveraged ETF.
    1. Event-Driven Strategies Work Well with Leveraged ETFs: When a significant news item comes out that affects an industry’s leading stock or its sector (i.e., JPMorgan’s huge trading loss), this is a great time to use leveraged ETFs instead of shorting JPMorgan stock. This is because sectors trend much better than stocks. If the whole financial sector is down significantly on one trading day, this is far more important and a better predictor than just one stock in an industry being down. Therefore, there are better odds that the direction of the industry will continue to trend down.
    2. Make Sure Fundamentals and Technicals Agree: The fundamentals should follow or match the direction of the trend or breakout that is occurring on the chart. A great example of this can be seen in crude oil. The supply/demand picture for crude oil has been very poor, with supply growing and demand weakening, but technically, this didn’t occur until we saw a head-and-shoulders breakout in crude in April. Since then, crude is down more than $15.

    See also: The Leveraged ETF Safety Kit

    By William Meade, contributor, Minyanville.com and Global Investor Monthly
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