Leverage can do remarkable things. With enough leverage, a 20% return can be transmuted into 100%. Of course, in the math world whatever is given can also be taken away. Plenty of investors (professional and amateur) have blown themselves up with leverage and that boost to returns in good times can turn around and bite ferociously when the play is wrong. Just ask the likes of Lehman Brothers what can happen when someone is highly leveraged and hits a rocky patch in the road.
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Investors have always had some tools at hand to add leverage to their investment decisions. From buying on margin, to investing in options, to playing the commodity markets, these are all ways of making $1 of investment capital go a little further in exchange for higher risks. Relatively recently, though, financial services firms have come out with new products for investors - highly-leveraged ETFs that look to multiply the returns of underlying markets.
Leveraged Plays on the Financials
For investors who have a very definite outlook on the financial services space and a love of leverage, there are a couple of ETF options to consider. The Direxion Daily Financial Bear 3X Shares (NYSE:FAZ) boasts 300% leverage to the inverse of the Russell 1000 Financial Services Index. In other words, if this large index of banks, financial services and insurance companies declines 5% in a day, the FAZ shares should be expected to rise 15%. Of course, that cuts both ways - if the index rises 5%, the FAZ shares will fall by about 15%.
If a three-times bet seems like too much, there is the UltraShort Financials ProShares (NYSE:SKF) which offer 200% leverage, but a similar basic mechanism (though UltraShort uses the Dow Jones U.S. Financial Services Index).
In both cases, investors pay 0.95% in annual expenses, but there are other costs to consider as well. Because of the extensive daily repositioning and the taxation of short-term gains, these ETFs are not as tax-efficient. Moreover, the derivatives used by these funds are marked-to-market at year-end, which also impacts tax efficiency.
Last and not least, investors should be aware of the cost of volatility drag. In simple terms, volatility drag is the difference between averaged returns and compounded returns caused by volatility. If you start with $100 today, see a 10% gain, and then a 10% loss, you are not back where you started. Instead, you have a 1% loss ($99). This matters because of the rebalancing of these ETFs and the fact that the returns match the index for only one day at a time. Consequently, holding these ETFs day after day in highly volatile markets can whittle away value and returns even if an investor has made a generally correct directional call. (For more, see Dissecting Leveraged ETF Returns.)
Other Options
Of course, investors do not have to employ leverage to make directional calls on the financial services sector. The Short Financials ProShares (NYSE:SEF) offer a straight single exposure, but the same 0.95% expense ratio. Likewise, investors who have a negative outlook on the financial services sector could simply short financial sector ETFs like Financial Select Sector SPDR (NYSE:XLF), Vanguard Financials ETF (NYSE:VFH) or iShares Dow Jones US Financial Sector (NYSE:IYF).
Shorting these ETFs has the usual drawbacks and risks that go with shorting. Investors' brokers have to locate the shares, and the investors have to pay dividends and interest on the loan. On the other hand, the uptick rule does not apply here and investors get a little headwind from the expense ratio that these ETFs charge their holders
Leverage does not just work in one direction, of course. On the flip side, financial services bulls can look at the Direxion Daily Financial Bull 3X Shares (NYSE:FAS), the Ultra Financials ProShares (NYSE:UYG), and the previously-mentioned financial service sector ETFs. In the case of FAS and UYG, investors will be using instruments that have 300% and 200% leverage respectively, with all of the risks and benefits that represents.
The Bottom Line - Not For Everybody, But Serves A Niche
While this article focused exclusively on the financial services options, Direxion offers 2x and 3x levered ETFs for a variety of sectors including energy, semiconductors, natural gas, and Treasurys, and ProShares likewise has a relatively wide array of investment options. The question then is not so much about "could" as it is about "should".
Clearly these ETFs are not for everyone. A novice investor has as much business employing leverage as a toddler does using a chainsaw. Likewise, those who are long-term buy-and-hold investors will find volatility drag to be very expensive. But for advanced investors looking to make a highly-concentrated, short-term directional play on specific sectors, levered ETFs offer the opportunity to magnify being "a little right" into a big win. (For related reading, Rebound Quickly With Leveraged ETFs and ETF Tracking Errors: Is Your Fund Falling Short?)
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