Yesterday on Blogtalk I had a call that I can only characterize as "disturbing."
The gentleman proffered a view that the various "levered" ETFs such as FAZ, FAS, SRS, etc were all in some way "defective", and even put forward an analogy to a car that blows up unless you read the instruction on page 176 of your owners manual.
This is pure crap, but it points out the sort of "Cramerica" approach that many people take to "investing" - that is, if it moves, buy it, if some crooner on the TV or internet recommends something you should either buy or sell it.
All of these ETFs have a thing called a "Prospectus", just as does a mutual fund. They're even available online, if you care to take the time to understand what you're buying before you buy.
These levered ETFs are promoted as a way for people who think that the market (or some segment of the market) will go up or down to take a "levered" bet - that is, one that will return more than the actual market in either the north or south direction - without using margin, buying options or being involved in the futures marketplace.
However, what people don't bother reading is the description; it typically is something like this:
"This ETF seeks to provide two times the daily performance of the S&P Index."
In point of fact these ETFs do exactly what they promise.
So why do I get callers like the gentleman yesterday (or the one the week prior calling about SRS), and why do we have buttclowns like Cramer calling for these things to be banned?
It is because a huge percentage of people in this country failed sixth grade math.
Let's take two of these funds and call them "SDS" and "SSO". Oh wait - there really are those, aren't there? SDS is 2x the S&P 500 "bearish", and SSO is 2x the S&P 500 "bullish."
Ok. We'll start with both at $100, to make it easy. So at the zero point in time we have:
SDS - $100
SSO - $100
Now on the first day, the S&P 500 falls 5% - fairly close to that happened yesterday. Remember, these funds are 2x the DAILY move of the S&P 500. So at the end of the first day we have:
SDS - $110
SSO - $90
Ok, now on the second day the S&P 500 rises the same 5%, ending exactly where it began. The two funds are:
SDS - $99 ($110 less 10%, or $11)
SSO - $99 ($90 plus 10%, or $9)
Heh, wait a second you holler! How come they're not back to $100? I got ripped off!
No you didn't. The funds did exactly what was promised - they returned 2x the S&P 500 on a daily basis.
So why the "loss" in both funds? Simple: it is called compounding, or in the mathematical parlance, exponents.
Now this is just two days, and from there you would probably conclude that these things are the spawn of the devil. But are they? Let's take another example - the S&P 500 rises by 5% for five successive days.
We start with SSO at $100 and we get $110, $121, $133, $146 and then $160 on the final day.
But wait! The S&P 500 rose 5% a day over five days (27.6% aggregate), but SSO is up sixty percent! I thought it was two times; where did the extra gain (about 5%) come from?
Ah, grasshopper, it is two times - two times the daily change. And in this case the magic of exponents works for you.
Everyone wants to gripe when things don't go their way, but who gripes when it works out for them? Who was complaining when SRS was nearly $300? Nobody.
In a back-and-forth market both of these "levered" funds will eventually wind up at zero, or very close to it. And, in fact, a perfectly valid strategy, assuming you have the margin capacity and can find a borrow, is to short them both and take advantage of the compounding. There are more than a few intelligent people who have figured this out and as such it is often difficult or impossible to find borrows on these ETFs for that reason.
In fact compounding - the law of exponents - is why investing works for the common man over long periods of time. It is why you save for retirement in some sort of vehicle that earns a return - over long periods of time, 20, 30, 40 years - compounding beats everything else when it comes to putting a sound financial foundation under yourself.
A 22 year old friend of mine who I've known since she was 13 or thereabouts has a father who had the foresight to buy a small passel of stocks for her when she was a baby in a UTMA account. The account is now under her control. She has several securities in that account, due to the magic of compounding, that are worth ten or even thirty times their original purchase price, all due to dividend reinvestment and compounding. The bad news is that if and when she sells them she will owe a crapload of capital gains tax. The good news is that it will be at the long-term rate. This portfolio cost her father a few thousand dollars back then. Now it is worth in the mid-five-figures. Not bad for a 20-something to have as a foundation. Oh, by the way, she's smart enough to not blow it on boys and booze too, recognizing that this could easily turn into the foundation of her retirement 40 years hence.
Gee, one 22 year old with a brain! Who'd a thunk?
These ETFs simply "pull down" the exponent period to daily rather than quarterly or annually as is the case with dividends. They thus give you a levered way to bet on the move of the market over a short period of time - a single day to a week or two - and if used properly they can be part of any trader's portfolio.
I trade these instruments with some regularity when I believe a major trend change is about to take place. While the "back and forth" may mean that I don't get exactly 2x the move, sometimes more and sometimes less, it is a means for me place that wager without paying for time decay (in the case of options) or worrying about margin (in the case of futures.) Last year in one of my IRAs (a very small account) I managed a more than 50% gain - in one year - placing just four round-trip trades. These were high-risk moves, of course, but they illustrate the power of these tools - when used properly.
Finally, these funds (due to using total-return swaps to get their leverage) tend to kick off HUGE distributions - sometimes as much as 20% or more of their price! Beware if you hold these into a distribution date in a taxable account as that distribution is taxable as a dividend even though you almost certainly didn't get the gain! Almost nobody who rants about these things bothers to account for the distributions, but you have to if you're going to actually "do the math."
I found the call yesterday on Blogtalk disturbing in that the caller implied that these funds were somehow "defective" and should not be sold to the public.
In fact what was defective (assuming the caller actually bought these and lost money without understanding how they work) was the caller's understanding of basic mathematical principles - things he should have learned in middle school.
That call said more to me about the state of our education system in this country than it did about finances. That we fail to educate our children about fundamental principles of mathematics that, 100 years ago, were part of a middle school graduation examination is outrageous - and disgusting. It is this lack of understanding of how exponents work, by the way that has led us to be the nation of sheep that got into this mess with housing in the first place, where people believed that house prices could rise 10 or 15% annually forever, while wages were rising at 0-2%!
NOBODY should get out of high school without being able to run that computation above and understand how these ETFs work. Nobody! Nobody should get out of high school without a very solid understanding of exponents and without being able to instantly recognize where they come into play in every life and economics.
If we had a nation full of citizens that had the knowledge of a middle schooler from the mid 1800s both The Internet bubble and The Housing bubble would not have happened, as the citizens of this nation would have called "bullcrap!" on both before they could have gotten going, and we would have seen both bubbles punctured before they could inflate.
WE are responsible for this mess and the one before it, just as we were in 1873 and 1929. We have willfully either failed to educate our children or willfully suspended our ability to think and reason. It is a direct consequence of this refusal to apply the basic laws of mathematics that leads us to where we are today, never mind the impending implosion of entitlement spending that cannot possibly be maintained.
Folks, get educated. You have nearly 1,000 Ticker articles here, all available. I have written about the magic (or curse) of compounding - the law of exponents - many, many times. That basic mathematical principle is at the root of 99% of the stupidity in our capital markets and political system when it comes to the promises such as Social Security, Medicare and other entitlement spending, along with the foolishness of both the Internet and Housing bubbles.
These messes have occurred because we the people are mathematical illiterates by choice, and we're not talking about complex subjects that are learned only in a college-level Calculus class either!
This is basic algebraic math folks - stuff you should have to know in order to get out of middle school, say much less high school.
In a land where most of our adult population holds a high school diploma there is no excuse for failing to understand how levered ETFs work - nor is there any excuse for believing in the fairies that led to either the Internet or Housing Bubble.
Nor is there cover for our so-called "elected officials", all of whom I presume also hold at least that same high school diploma.
Wake up America, and while you're at it make damn sure your kids "get it" - even if you don't.
Audio Streams
