Reasonably Thinking

Leverage is a tool that magnifies efforts.  Whether it is Archimedes moving the earth or Wall Street titans moving financial markets, leverage enables doing more with less.  Consequently, when leverage or any other tool is inappropriately used, the harm inflicted is also magnified.

I argue that leveraged exchanged traded funds cause more harm than good to retail investors.  As I discussed two weeks ago, the geometric compounding effect of levered ETFs is more impactful to the downside than beneficial to the upside.  Take for example the Direxion Daily Financial Bull 3x Shares FAS and Direxion Daily Financial Bear 3x Shares FAZ.  These funds aim at returning 300% of the daily move of a financial index, and they generally perform as stated.  However, holding these securities beyond a day subjects an investor to harm.  One could imagine that since FAS and FAZ seek to return exact opposite daily returns, over a year time period the sum of the returns would net to zero.  That, however, is not the case.

(Image from MarketWatch)

Over the past year, FAS performed -40% and FAZ performed -26%.  The lesson is that investors should avoid long positions in these securities and instead consider shorting these securities.  So, if I believe the financial sector has good prospects, I should short FAZ; if I believe the financial sector has dire prospects, I should short FAS.  Instead of using the long to go long and the short to go short, I should short the short to go long (short FAZ) and short the long to go short (short FAS).

Since I am bearish on the market and financials, I desired a short financials position and accomplished this by shorting 150 FAS at $13.55 (shorting the long).  I partially funded this trade by covering my short UYG position.  UYG is a financial levered ETF that seeks to perform 200% of a daily financial index.  This trade simply upgrades me from shorting 200% to shorting 300% and deploys more cash to a short allocation on a market advance.

Keeping Score