Bad Investment Advice From Forbes
In my experience, most financial advice from financial journalists and experts takes two forms. The first is very broad, and typically covers the fundamentals that any investor must get right: diversify; own a mix of stocks and bonds; keep an eye on the long-term, etc. Encouragingly, many of the most popular and widest read outlets recommend that investors achieve these basics via broad market index funds or exchange-traded funds.
The second assumes that the audience has a higher base level of investment knowledge, and deals with tinkering around the edges of one's portfolio. In my opinion, the advice at this level ranges from silly ("this manager is really smart, so you should think about owning his fund") to downright worrisome. A recent column in Forbes by Bill Baldwin falls squarely into this category.
In the column, entitled "How to Use Those Supercharged ETFs," Baldwin makes a case for "sober people with long investing horizons" using leveraged ETFs in their portfolios. The case against these ETFs -- which attempt to double or triple either the return of a benchmark or the inverse of its return -- has been made quite often, most notably by me and my MoneyWatch colleagues Allan Roth and Larry Swedroe.
The objection to them, simply, is that when they're held for longer holding periods, the return they provide often has nothing to do with the performance of the benchmark it tracks, particularly in volatile markets, as I illustrated in a 2009 post with this example:
Assume that you invest $100 in a traditional index fund, and $100 in an ETF designed to double the index's return. On first day, the index increases 10 percent, thus you have $110 in the traditional fund, and $120 in the leveraged fund. The next day, however, the index plunges 20 percent. Your traditional fund falls to $88, and the leveraged fund falls to $72. On the third day, the market rises 15 percent. Now, your traditional fund is up to $101, while the leveraged fund's value is only $94.As you can see, the return of the leveraged ETF was not double the index's 1 percent return, but -6 percent. Because they behave this way, the Financial Industry Regulatory Agency warned that these funds were unsuitable for holding periods of longer than one day.
But Forbes' Baldwin isn't buying it. While he acknowledges that "leveraged ETFs do badly in volatile markets," he notes that "they outperform during trends" (i.e. periods in which the market moves in one general direction), which causes him to recommend their use as a hedge against inflation or rising interest rates.
Yes, it's true that these funds can perform spectacularly well if the market is moving in one direction. And yes, investors in such a fund can reap tremendous rewards in such a period. But the important point that's missing from Baldwin's analysis is just how an investor is supposed to determine that the market will be "trending" in one direction over the coming days, weeks, or months.
One year ago, for instance, you would have been hard-pressed to find anyone with a pulse who didn't believe that Treasury rates would rise in 2010. The ten-year Treasury was then yielding about 3.7 percent -- up roughly one percent from its 2009 low, but still well below its long-term norm. Surely, the conventional wisdom went, the recovering economy and inflationary pressures would push rates higher in the year to come.
Yet here we are, a year later, and rates have actually declined. Thus an investor who sought to profit from what seemed inevitable using the Direxion Daily 20+ Treasury Bear 3x ETF (a leveraged ETF that would profit from rising interest rates) would have found themselves saddled with a 37 percent loss for the year.
So yes, Baldwin is right that investors who posses the knowledge of what direction the market will head -- and whether that ride will be smooth or choppy -- will find it rather easy to make buckets of money using leveraged ETFs. As for the unwashed masses who are unable to see precisely what the future holds, they're far better off avoiding such funds.
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