I’m not much of what one would call a trader. Many investors are drawn to more regular trading. For those seeking guidance or simply looking for an additional perspective, I highly recommend reading Smart Money’s 7 Habits of Highly Effective Traders.
In part one I focused on the ability to easily buy or sell a stock in explaining why being an owner of a company through stock is different than actually being a regular business owner. In this second part I will discuss borrowing on margin, margin calls and why they create a different climate for an owner of stock that does not exist for a regular business owner.
When investing in stock, investors have the option of using a margin account to leverage their purchasing power. Such an account can be used for regular stock purchases, covering short positions or futures, such as option contracts.
When sudden market declines are seen in the market it is not uncommon for an increasing number of investors to receive margin calls from their lender/broker. This happens because a specific reserve requirement must be maintained by the investor. When markets tank, the devaluation of the investor’s portfolio can cause the investor’s minimum maintencance margin to be insufficent.
To address the margin call investors often are forced to sell stocks they currently own to the meet the minium maintenance margin. This act from one investor to the next puts further downward pressure on the market. Therefore, the negative pressure on stock prices is exacerbated.
A regular business owner may take a loan out to cover business costs, but the circumstances that impact his/her ability to pay back that loan are much more narrow in scope than what we observe with margin calls. The owner knows that X, Y, and Z must happen for sufficent revenues to come in during a time period to cover the loan payment. Conversly, an investor cannot possibly count the number of variables that can cause the market to experience a sudden downdraft.
The ability for an investor to leverage buying power through the use of a margin account is not all that different from a loan a business owner establishes. The real difference is the number of variables each respective party is subject to. The market can be like a kite in the wind and therefore subject all investors using margin to its bobbing and swoops downward. In a short time a lot of liquidation can be forced to occur.
Leveraged ETFs have been around a while and continue to grow in the variety. For investors looking to use leverage without the use of a margin account or purchasing specific derivative instruments, leveraged ETFs might be a viable alternative for you and your portfolio. Though an easy way to position yourself to maximize market returns, ETFs are not without downside. Do the benefits outweigh the costs? Should you consider leveraged ETFs in your portfolio?
One of the main considerations you must make as an investor is how much return do you need or expect from your investments? If you decidedly wish to beat the market, then leveraged ETFs will be an alternative to consider. Not everyone is committed to stock selection. Many seasoned investors will simply invest based on their conviction that this is either a bull or bear market. Therefore, such an investor would have an even greater inclination toward leveraged ETFs.
Leveraged ETFs are able to maintain their 2x, 3x, or 4x exposure to the market through the use of derivatives, such as index futures, equity swaps and index options. The way that a leveraged ETF is constructed calls for constant re-balancing (daily). By re-balancing I mean that the ETF must adjust to keep the exposure the fund seeks to achieve.
To illustrate the point of re-balancing, suppose that I have a fund with $1,000 in assets and $2,000 in index exposure to the S&P 500 (2x leverage). If the index rises 1% on a given day my assets rise to $1,020 (I reflect a 2% gain since the fund is leveraged twice the market), but I must re-balance so that my exposure increases to $2,040 for the next day of trading. This is a constant process that must go on.
The process described above is a simplified example, but it should be obvious that such constant re-balancing is going to cause leveraged ETFs to incur larger maintenance/management fees than un-leveraged ETFs. Fees will vary per ETF, but on average be prepared to be hit with much higher fees than what you’d receive from a plain vanilla index ETF.
As a result of their nature, leveraged ETFs are going to work best for you if you’re able to get in on the floor of a market rally. It gets back to the basic idea of compounding. Day after day increases in the market’s price is going to compound just as any other investment you have does. If the market is flat and going to get nowhere all your going to get hit with are high maintenance fees or, if the market goes against you, your portfolio will be severely rocked.
In conclusion, I am of the opinion that leveraged ETFs are a good tool, when used correctly. These investment tools are not something that should be used by investors looking to buy, hold and ride out the market. Investors that have strong opinions about which way the market or a particular industry is heading in the near-term would be a best fit for leveraged ETFs. They’re particularly valuable for those investors that do not wish to establish margin accounts and directly engage in the purchase of derivatives.
If you feel that your sense of general market movements is keen, then give leveraged ETFs a look. You will find ETFs that are leveraged for both market appreciation and depreciation. It doesn’t matter if you’re a bull or bear, the leveraged ETF universe has a product for you.
Resource: List of Leveraged ETFs