“Even Crack Dealers Wouldn’t Be Ok With This” – 4X ETFs And The Idiot Tax

When it comes to stories about why ETFs are generally dangerous and why these vehicles are a textbook example of how one can indeed have “too much of a good thing,” our output has been voluminous.

To many, the proliferation of low-cost, passive investing vehicles is seen as an unequivocally positive development. And indeed, it’s unquestionably a good thing that retail investors have access to instruments like SPY, which allows them to get exposure to the index for under 10 basis points.

The problem comes in when, thanks to central banks effectively bidding up every benchmark on the planet, investors start to believe that “buy and hold” is actually a “strategy.” That’s a popular delusion. A misnomer. “Buy and hold” isn’t a “strategy.” It’s more like a truism. Buy stocks, hold them for seven decades, generate good returns.

Too many retail investors have fallen into the trap of thinking that because they bought an equity index fund in early 2009 and have profited handsomely while active managers have seen their alpha disappear…



… that they (the retail investors) are gurus.

What they fail to realize is that the chart shown above is no coincidence. That is, it isn’t by happenstance that anyone with some shares in an S&P ETF suddenly became a “better” investor at precisely the same time that virtually avery active manager on the planet ceased to be able to best their benchmark. There is a simple explanation for this phenomenon. This is what that explanation looks like in “stock” terms:



And this is what that explanation looks like in “flow” terms:



Of course “success” begets more inflows which means that as central banks continued to push benchmarks ever higher, investors continued to funnel more money into ETFs, effectively mistaking a long-term truism (“buy and hold works over multi-decade horizons”) for a short-term “strategy” (all we have to do is buy ETFs on any dip).



This has created all manner of distortions. Buying benchmarks indiscriminately invariably leads to the misallocation of capital as money is thrown disproportionately at the companies that are the most heavily weighted at the index level. Further, investors are blissfully ignorant to the myriad dangers associated with the creation/destruction process that makes ETFs work (ETF providers and APs are happy to perpetuate the illusion that the process is streamlined, intuitive, and simple when in fact it is anything but). Finally, investors have no clue how illiquid the market is for some of the assets that sit beneath their shares which trade on an intraday basis with the illusion of liquidity. For on of the best takedowns of ETFs we’ve read to date, see “Today’s WMD Is A Three-Letter Word: ETF.

In the final act of this shitshow, ETF sponsors begin to see an opportunity to exploit clueless retail investors’ voracious appetite for ETFs. Witness the comical “ETF ETF” which we contend you’d have to “be a special kind of retarded to buy,” or, even better/worse, the “long Jesus” ETF which we lampooned earlier this week.

One last thing to note is that ETFs turn retail investors into derivatives traders. ETFs are derivatives. Yes, that characterization lacks nuance and there are some caveats, so maybe “pseudo-derivatives” is better. Either way, you do not want to turn hordes of retail investors who, thanks to central bank largesse, think they are invincible, into derivatives traders of any kind.

The latest iteration of ETFs gone wild are 4X levered vehicles, an “innovation” that was approved by the SEC on Wednesday. Specifically, we now have ForceShares Daily 4X US Market Futures Long Fund (which of course uses the ticker “UP”), and ForceShares Daily 4X US Market Futures Short Fund (“DOWN”).

Simply put, this is dumber than a pile of bricks. And in order to spare you a profanity-laced diatribe (there are a couple of those in the posts linked above if you enjoy that sort of thing), we’ll let Bloomberg’s Cameron Crise explain why…


Via Bloomberg

Leveraged ETFs Tax People Who Are Bad at Math

I read with some interest and not a little disgust this week that the SEC has approved the rollout of 4x levered ETFs available for retail investors. In an era where regulators are keen to aggressively punish perceived malfeasance from the finance industry in FX and Libor fixings, it’s odd that they approve of a product that seems singularly designed to separate the public from its money.

  • The issue with leveraged ETFs is that while they endeavor to generate some multiple of an underlying asset’s percentage return, there is no undertaking to produce a multiple of the dollar return. As anyone who’s ever managed money can tell you, this is an important distinction.
  • Let’s use a stylized example to illustrate the difference. Imagine you invest $1,000 in a 4x levered ETF on the S&P 500, thereby taking $4,000 worth of risk. Immediately afterward the index suddenly drops 10%, so that $4,000 is only worth $3,600, and that $400 loss makes your ETF holding worth $600.
  • To maintain the correct leverage ratio, the ETF manager has to sell $1,200 worth of SPX on your behalf to reduce your exposure to $2,400 (4x the value of your ETF holding.) On an unlevered basis, the index only needs to rise 11.1% to get back to its starting point. However, it needs to rally 16.7% to turn your $600 back into $1,000 (i.e., a $400 return on $2,400 of exposure.)
  • To maintain the correct exposure ratio, levered ETFs add risk when the market goes up and reduce when it goes down. That’s OK if the market moves in a straight line, but can get very very expensive if there is choppy price action.
  • An excellent real-world example is GDXJ and JNUG, the junior gold miners ETF and its 3x levered equivalent. Since the start of last year the annualized percentage return of GDXJ has been 46%, while JNUG has delivered three times that: 140%. Happy days, right?
  • Not quite. If we look at the actual equity curves, a very different story emerges. GDXJ has returned 52% since the start of last year, which is what you’d expect. JNUG, on the other hand, has returned an aggregate of just 9% in cash terms.
  • A defense of these type of products is that they are used primarily by professional investors to take targeted risks or day traders to take short term punts. That’s fine, but if it really is the pros doing the trading in this, why not make them futures (with the requisite risk disclosures?) Why give grannies and dentists the chance to dabble with compounding risks that they almost certainly don’t understand?
  • There’s an old joke that lotteries are a tax on people who are bad at math. Highly leveraged ETFs are not just a tax on those folks: they could be a financial death sentence.


Here’s what Sal Arnuk, a principal at Themis Trading said about these ETFs back in January:

The amount of money pouring into ETF’s continues at a staggering pace.  According to ETF.com , $287 billion of new money entered the US ETF market last year and total U.S.-listed ETF assets grew to $2.56 trillion.  While ETF’s serve a very useful purpose by allowing investors to diversify at a low cost, it’s important to remember that not all ETF’s are the same.  Some of the larger ETF’s like SPY and QQQ are backed by the actual securities in the index but there are a number of other leveraged ETF’s which contain derivatives in their holdings which could cause tracking and risk issues.

While most investors are familiar with these 2x and 3x leveraged products, a new ETF has just been proposed which would up this leverage to 4x.  The product is known as the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund (the proposed symbols are “UP” and “DOWN”).  NYSE Arca proposed to list these but the SEC announced on December 14th that they need a longer amount of time to decide if they will approve or disapprove the listing.  We’re glad that the SEC delayed a decision because these products look like they could be extremely dangerous for investors.  We reviewed the ForceShares Trust Form S-1   and found the below risk factors to be very concerning :

— the Sponsor has no experience operating commodity pools

— the Sponsor is “leanly staffed” and “relies heavily on key personnel to manage trading activities”

— the success of a Fund depends on the ability of the Sponsor to accurately implement its trading strategies, and any failure to do so could subject the Fund to losses.

— the Sponsor may have conflicts of interest, which may cause them to favor their own interests to your detriment…the Sponsor’s principals, officers or employees may trade futures and related contracts for their own accounts.

— the Sponsor has limited capital and may be unable to continue to manage the funds if it sustains continued losses

— the failure or insolvency of the Custodian for a Fund could result in a substantial loss of the Fund’s assets.

— the Funds are not registered investment companies, so you do not have the protections of the 1940 Act.

There are plenty of questions regarding the specifics of this product but the real question is: does the market really need a 4x leveraged product?  If the SEC approves this product, then what is to stop a company from trying to list a 5x, 10x or even 100x leveraged product?

We think that the SEC should also use this opportunity to create new guidelines for leveraged ETF products.  In particular, investors should at a minimum have to sign an agreement similar to the Options Disclosure agreement which states that they fully understand the risks associated with leveraged ETF products.

This is market crack, and it concerns me,” Arnuk told CNBC this week, adding that “I can’t imagine how [the SEC] would read their disclosures and be OK with the product even if they were OK with the philosophy of giving crack.”

Yes, even someone who was “ok with the philosophy of giving crack,” wouldn’t approve these two funds.

Which we suppose explains why we can’t endorse them.

Urz truly on a Saturday,


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3 thoughts on ““Even Crack Dealers Wouldn’t Be Ok With This” – 4X ETFs And The Idiot Tax

  1. Arguably the most surprising news here is that after so long in the ETF bubble, the tickers UP and DOWN were still available.

    The other arguments are presumably as applicable to the existing 3x ones as the new 4x ones.

    Interestingly, I think, although I’m not a tax lawyer or an idiot, that under Canadian tax law at least, in a self-directed retirement savings account you can only buy “responsible” investments like shares on a stock exchange, not “speculative” investments like futures. So a 4x leveraged ETF would be just dandy.


  2. It would be more instructive to show a longer time frame. As far as I know active managers have always been beaten in after-cost returns by passive funds—not just since the advent of QE as you seem to imply.

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