How would you feel if your best friend and next door neighbor was metamorphasizing into a monster? A Dr. Jekyll and Mr. Hyde if you will. Could that be happening to our old friend, the Exchange Traded Fund? The historical definition of an ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. They provide the diversification of an index fund so for those looking to get started in covered call writing with limited cash, this may be an avenue to explore. I have been selling covered call options on the Qs (QQQQ) in my mother’s portfolio for years generating hundreds of dollars per month into her account.
Recently, however, the definition of an ETF has started to change. Some are actively managed and aren’t required to follow the complexion and market capitalization of an index. These more aggressive funds offer the possibility of greater returns but also represent a higher degree of risk and administrative costs. If your mission statement includes risk reduction, you need to be aware of the pros and cons of such ETFs.
Taking this Jekyll and Hyde analogy to a higher level, we now have the introduction of leveraged and inverse exchange-traded funds. Leveraged ETFs, sometimes called “ultra” or “2X”, use futures or derrivatives to multiply the daily returns of an index. Inverse ETFs look to return the opposite of the index, or double or triple the opposite of the return of that index.
After the impact that leveraging had on the real estate industry the past two years and its subsequent devasting effect on our economy, regulators appear to be voicing their concerns. On FINRA’s (Financial Industry Regulatory Authority) website recently, brokers and investment advisors were reminded that these instruments are complicated and usually not suited for retail investors (that’s us folks) who plan to hold them for more than one trading day! The notice continued…..”Due to effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective.”
Paul Justice, an ETF expert with Morningstar, says leveraged and inverse funds are appropriate for fewer than 1% of the investing community, but still have attracted billions of dollars. Wasn’t there a lesson learned from leveraged real estate investing?
Let’s look at two such funds:
The Direxion Daily Financial Bear 3X Shares (FAZ) seeks daily returns of three times the inverse of the Russell 1000 Financial Services Index, is down 85% year-to-date.
The Direxion Daily FinancialBull 3X (FAS) seeks daily returns of three times the Russell 1000 Financial Services Index, is down 67% in this same time frame. Check out these charts and see if these ETFs are right for you:
These leveraged ETFs do have a place in the portfolio of some. It is important to understand the risks as well as the rewards and make an informed decision based on the facts rather than getting carried away with profit potential alone.
The main point I want to make to all my fellow Blue Collar Investors is that some ETFs no longer represent the relative safety associated with the older generation funds. The previous funds certainly still exist but their offspring have had a genetic mutation that we must be aware of. FINRA seems to be all over this and so should we.
Screen of the Day:
The IBD website has a tool called Screen of the Day. This past Friday’s screen was for great performing small cap stocks. Every so often, I will run such stocks through our system criteria and see if there are any gems to add to my watchlist. I found three:
Below is the chart pattern for QSII, the best looking chart of the three:
Check out all three charts and see if these stocks belong on your watchlist. Remember, placing a stock on your portfolio watchlist does not mean that you will purchase it this month. That depends on other system criteria like ERs, technical analysis for buy-sell decisions , calculations and diversification issues. You can use this technique for equity location with other lists like IBD’s Stocks on the Move or any other quality screening list. For example, from time to time, I will screen the stocks in the top performing industries and see which ones meet our system criteria. Those following this site know that I have reported some of these stocks on the comments link of my blog articles periodically. I encourage you to share your findings with the rest of our group.
Economic News of the Week:
Once again, we see several positive signs of economic recovery, the so-called “green shoots.” Sales of exisiting homes increased for the second consecutive month while sale of new homes remained relatively stable. Personal income increased by 1.4% mainly as a result of the stimulous money. The Fed kept its target rate funds in the 0% – 0.25% range as it anticipates ” a resumption of sustainable economic growth.” The GDP continued to decline but not as sharply as previously anticipated. Durable goods orders increased a surprising 1.8% in May despite predictions of a decline. For the week, the S&P 500 fell 0.3% for a year-to-date return of 2.9%. Those of you paper-trading sucessfully in this volatile environment are in for quite a ride when the market becomes more predictable and turns at least neutral and perhaps even moderately bullish. Your paper-trading due-diligence will be handsomely rewarded.
Video now playing on the homepage:
Last chance for book discount:
As a courtesy to my loyal readers, this is a heads-up notice that the $5- early order discount of Exit Strategies for Covered Call Writing with the Expiration Friday DVD will end this week. Demand for the book far exceeded my wildest expectations and I thank you for that. Here is the link to be eligible for the last minute discount:
My best to all,
Alan ([email protected])