You might be interested in buying a leveraged stock or commodity ETF. These are funds that magnify market returns. A leveraged fund might perform twice as well (or poorly) as a typical fund.
If you are concerned about inflation you might look for commodity ETFs to shield you against that problem. And if you are very bullish (or bearish) about the market, a leveraged fund might catch your eye.
Let’s say you are sure the market is going to go up by 20%. In that case, you might start looking around for a leveraged fund that will rise double that or 40%. It’s a sure thing…right? (Don’t count your chickens before they hatch, little Pilgrim.)
On the other hand, commodity ETFs are ETFs that buy commodities. Pretty simple. You think coffee is going up? Buy a coffee ETF. You like Platinum? Buy an ETF that owns only platinum. There are hundreds of ETFs that buy individual commodities.
(If you are interested in leveraged stock and /or commodity ETFs, you’re not alone. The ETF market (as a whole) is exploding. According to Investment News Magazine, ETFs now have over $1 trillion in assets. A good portion of that money is invested by individuals like you, and that has some people in Washington worried. In fact, the flash crash from May of last year was linked to commodity ETFs, and smaller investors got their clocks cleaned as a result. Bloomberg Business Week calls commodity ETFs the worst investment in America. Leveraged stock ETFs aren’t far behind.)
So why am I dishing the dirt on these investments?
1. Leveraged and commodity ETFs are complicated.
The SEC fears that many investors simply don’t understand how leveraged ETFs and commodity ETFs work. Leveraged funds try to capture a multiple of the market’s returns as I said. If the market rises by 2% this week, a double-leveraged ETF might get double that. Of course, the opposite is also true. As the market declines, these leveraged ETFs will decline much faster than non-leveraged ETFs. The way these funds get the leverage is by investing in derivatives and debt instruments. Most investors don’t understand these investments, so they couldn’t possibly understand the ETF that holds them either.
2. Leveraged and commodity ETF performance is mixed.
According to the SEC, many commodities funds (which are supposed to track the performance of the underlying commodity) don’t perform. In fact, their performance may be quite different than the commodity they track.
Because of these two issues, the SEC is considering slapping on suitability requirements for investors who put money into these types of funds. In my opinion, that’s got to mean they expect trouble and want to pull a little CYA.
3. You might think you are sure, but you can’t be.
People tell me all the time that given one set of circumstances or another, a certain investment outcome is inevitable. Let me share with you that there is no such thing as an inevitable investment outcome. There are too many variables. There are forces acting on investments that you aren’t aware of.
To make matters more difficult, you have to get your timing perfect too. (I do believe there are timing strategies that work. I believe that certain timing methods can help you improve your performance. I don’t believe that timing based on hunches is ever a good idea.)
I met a gentleman who was sure a certain bank stock was going to do gangbusters after the financial collapse in 2008. He was right…and he still lost money. How? He held the stock until it skyrocketed which was great. But he kept holding it when the rocket fell back to earth. This wasn’t a commodity ETF or leveraged fund but it illustrates the point.
I’m not a fan of investing in products I don’t understand. I also don’t like investments that don’t deliver the results they should. Finally, I don’t like buying an investment when my success depends on getting the timing right perfectly.
How do you feel about commodity ETFs and leveraged stock funds? Have you had a good experience?
Other Resources:
Bloomberg – ETFs Imperil Investors
Market Watch – Commodity ETFs: Toxic, Deadly, Evil
Mark says
January 3, 2012 at 12:04 PMVery good article Neal! I completely agree with you on leveraged ETF’s. From personal experience, these have been some of the worst performing funds that I have owned in the past. I think the big kicker is that the 2X leveraged funds return 2X the DAILY value of the underlier. This means that even if the underlier moves in your favor, in a very volatile market, you can still end up losing money (try it out in Excel with up and down movements of 10% for the underlier and 20% for the leveraged fund to see the effect in a short time period). These funds are only good for holding periods of a few days if you’re trying to bet on market movements.
I think commodities will do very well in the long term, and I don’t always want to own some of the mining, oil, and agricultural companies. Like you said some commodity ETFs have significant tracking error, which usually occur in contango markets. I use DJP for my commodity exposure, which is an ETN that has about 1/3 Energy, 1/3 Agriculture, & 1/3 Metals (Precious and Non-Precious) exposure. Being that it’s an ETN, it won’t have the same tracking errors as the ETF, but you have credit risk with the counter party that underwrote the note.
Neal Frankle says
January 3, 2012 at 12:07 PMI have also used DTN. It’s very well balanced. I don’t like a very focused commodity index. That is only good for people who really know that particular market. Thanks for the very informed comment.