The Mechanics Of Leveraged Exchange-Traded Funds: Appropriate For Covered Call Writers?

Our premium members receive a weekly report of exchange-traded funds (ETFs) appropriate for covered call writing. These lists will never include a leveraged ETF because we  feel that these securities are too risky and suitable only for sophisticated investors with high risk-tolerance. In this article, I will break down the mechanics of how leveraged ETFs work and demonstrate why it is not suitable for many retail investors.

Leveraged ETFs use a series of investment strategies such as short-selling, purchasing put options and using futures contracts to magnify the performance of the index that the ETF is tracking. They are constructed to return 2x or 3x of the underlying index value. As an example, if an index is up 1% in a day, that leveraged ETF would be expected to rise by 2% or 3%that day. Many use the term Ultra in their names.

Daily re-balancing and long-term results

Fund managers are driven to trade derivative securities such that at the end of a trading day the fund meets its advertised performance. Because of this daily re-balancing of the funds, the long-term results may not be the same as its advertised objectives. As long as the index increases in value the stated leverage will be met. However, if the index drops in value, the leveraged ETF will be worse off than the expected value based on its stated objective. Let’s set up an example to explain these concepts:

• Ultra BCI is a leveraged ETF with the objective of generating 2x the returns of index XYZ
• Share value = $20
• Index value = $1000
• On day 1 the index rises 10% to 1100
• Ultra BCI rises 20% to $24
• On day 2 the index drops back to 1000, a decline of 9.09% (100/1100)
• Ultra BCI drops by 18.18%($4.36)  to $19.64
• While there was no change in the index after 2 days, there was a 1.8% decline in share value

QLD: leveraged ETF looking to return 2x that of QQQ (Nasdaq 100):

To further demonstrate how the funds leveraged objective does not usually hold true long-term, let’s view a 5-year comparison chart of QQQ (black line) versus its leveraged partner QLD (2x) (blue line):

QLD vs. QQQ

Note how QLD performed much better than its stated 2-to-1 objective long-term as QQQ rose precipitously over the past 5 years.

Tax implications:

Because of the nature of the derivatives employed to reach the funds daily stated objectives, investors are subject to a complicated set of tax rules and therefore are not as tax efficient as standard ETFs.

Conclusion:

Leveraged ETFs are not appropriate for most retail investors because of the risk and high volatility. It is particularly inappropriate (in the eyes of this investor) for conservative investors utilizing a conservative strategy like covered call writing. For sophisticated investors with high risk tolerance this may be a useful security to use.

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Chicago: Saturday November 9, 2013

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Market tone:

As has been the pattern since this site went bullish on the market in the 2nd quarter, 2009, the weekly economic reports were mixed to positive. Here is a summary of this week’s reports:

• The Federal Reserve’s Federal Open Market Committee (FOMC) decided not to ease it policy of buying $85 billion a month in bonds in order to decrease long-term interest rates
• The Fed also reiterated its plan to keep short-term interest rates near zero citing a slowing in the housing market as one main reason
• According to the Institute of Supply Management (ISM) the ISM manufacturing index rose to 56.4, better than the 55.0 expected
• New manufacturing orders remained above 60, a bullish stat for our economy
• New export orders also increased indicating a strengthening of economies in China and Europe
• The nation’s industrial output from mining, manufacturing and utility plants, increased by 0.6% in September , above the 0.4% anticipated
• Retail sales decreased by 0.1% in September, below the + 0.1% expected. This was mostly due to the decline in auto sales
• Excluding autos, retail sales actually increased by 0.4%
• The Conference Board’s consumer confidence index dropped to 71.2 in October, below the 75.3 expected
• Inflation remains in check as the Producer price Index (PPI) fell 0.1% in September while analysts were expecting a rise of 0.2%. This was due mainly to a decline in food prices
• Compared to one year ago, PPI decelerated by 0.3% in September from 1.4% in August
• The Consumer Price Index (CPI) rose by 0.2% in September partially due to rising energy prices
• Compared to a year ago, consumer inflation decelerated to 1.2% in September  from 1.5% in August
• The Social Security Administration declared that benefits which are tied to inflation would rise by only 1.5% in 2014

For the week, the S&P 500 rose by 0.1% for a year-to-date return of 26%, including dividends.

I’ve had numerous inquiries in the past few weeks from new members asking how I assess market tone. As stated in my books and DVDs, I use three resources: Chart analysis of the S&P 500 as well as of the CBOE Volatility Index (VIX). In addition to those factors, I carefully evaluate the economic reports on a weekly basis…the ones I outline for you each week in my blog articles. Here is a 5-year chart showing a rising overall market and a calming and declining VIX over that time frame:

5-year chart of S&P 500 and the VIX

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1

Thanking you for your continuing support,

Alan ([email protected])

www.thebluecollarinvestor.com