The Danger of Investing in Two Specific ETFs

08/31/2010 12:01 am EST

Focus: ETFS

Corey Rosenbloom

Founder and President, Afraid to Trade

As we wind down August 2010 and get ready to start a new month, let’s take a quick look at the daily charts of leading financial ETF XLF and popular double-short (double inverse leveraged) fund SKF. There are some interesting things to note.

First, the XLF daily chart:

Click to Enlarge

Starting with what jumps off the chart at you, we see the similar range-bound rectangle trading range between $15.00 and $13.50 that we see in the S&P 500, and those will be the price reference levels traders will be watching. Until proven otherwise with a breakout, we would expect price to remain within this range.

But there’s something else that you should note. Remember that the S&P 500 is supporting at the 1,040 level— above the July 2010 low of 1,010. That means the S&P 500 is currently forming a higher low on the August low, while the financials (XLF) fund is forming a lower low.

That’s important to note, as many investors see financials as a leading fund over stocks. Right now, it’s just an interesting note that XLF just made a fresh new 2010 low (by a few pennies), while the S&P 500 (and other US equity indexes) remains above the July 2010 lows.

Otherwise, we have a positive momentum divergence in the 3/10 oscillator and two bullish “power” candles that could forecast a rally at least to the $15.00 level. Look for that to develop if indeed price remains in its short-term trading range.

With that being said, a lot of traders turn to the leveraged funds to get more mileage from moves in the financials (or other ETFs). That’s fine if you’re an intraday trader, but let’s take a quick look at SKF, a popular leveraged inverse financials fund, to see why “investing” in double inverse funds can get you in trouble.

Now, the SKF daily chart:

Click to Enlarge

Compare the two charts visually very closely. The XLF (like the S&P 500) had a key swing low in February as the SKF fund pushed to a new 2010 high— that’s what we would expect.

Then, the market rallied nonstop off that low to peak in late April ahead of the “flash crash.” Of course, the SKF suffered a steep decline during that three-month period, bottoming in April at the $17-per-share level.

As the XLF fell sharply, the SKF rose appropriately, but not back to test the high of the year, as was the case when XLF tested the low of the year.

Even more blatant is the fact that the XLF—and broader markets—broke to fresh new 2010 lows in July. A casual observer would expect SKF also to rally to fresh new 2010 highs, but this was clearly not the case.

That’s the danger to investors in these leveraged funds. They track day-to-day changes in terms of percentages, but do not track in the intermediate or long term.

In other words, inverse leveraged ETFs are deteriorating vehicles that will continue to wind their way lower and lower and lower over time. But that’s a whole other discussion.

Anyway, as XLF formed new 2010 lows, SKF peaked at the $24.50 level, down around 8% from its 2010 high.

Now, as XLF made another small fresh new 2010 low recently, SKF made another lower high when it “should have” (to the casual observer) made a higher high. Instead of making that higher high, SKF was comparatively down about 3.5%.

Look closely also to find that instead of simply testing the double bottom at the start of August as the XLF tested a “double top” at $15, the SKF actually made another lower low.

Anyway, keep this in mind, and be certain to read the prospectus of any ETF you purchase.

Also, be aware of the realities of the deterioration over time of leveraged ETFs. Once again, fine if you’re using them as intraday trading vehicles to get more mileage (profit) from your positions, but not fine if you are investing in them.

Even Jim Cramer gets riled up about this topic!

By Corey Rosenbloom, trader and blogger,
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