Leveraged ETFs – The Leverage Mix-UP

I’ve come across many market participants believing if they purchase a leveraged ETF and held it for an extended period of time, the ETF’s performance should double the index or sector it’s benchmarked against.

Please understand this is not the case. The majority seek to provide a 200% DAILY return on the underlying index they track.

Notice I typed “DAILY”!

Noted in the ETF providers prospectus, which I’m sure we all read quite diligently. It is stated the leveraged ETF is designed to double the Daily return, not the total return for time periods greater that one day.

I noticed this while I was helping a hedge fund that trades ETFs quite heavily. The were using the leveraged ETFs to hedge the portfolio and noticed the hedge was not delta neutral. The hedge was actually appreciating more than what the underlying portfolio was depreciating.

So, why does this happen? Why doesn’t it track properly if market participants hold positions overnight? Compounding! Just as we all like compound interest you get the same effect here, except since the ETF can depreciate in price it can work adversely too.

Over time the effect of compounding and leverage can have a significant effect on the total return of the ETF.

Here is an example assuming a $10,000 investment.

Day 1:

The underlying index increases 1%
The leveraged ETF increases 2%

The first day = 200% return, just as we thought, and we outpaced the market, great!

Day 2:

The underlying index decreases 1%
The leveraged ETF decreases 2%

Underlying Index Value: $9,999 (An increase of $100 and then a decrease of $101 on day two)

Leveraged ETF Value: $9,996 (an increase of $200 and then a decrease of $204)

As you can see the index decreased in value $1 over two days and the leveraged ETF decreased $4 over the two days (this is four times the cumulative index loss as opposed to two times the loss).

Hopefully, I’ve explained this in detail enough for you to see how over a longer period of time the cumulative percentage change of the leveraged ETF has the ability to vary significantly from the underlying index.

Here are a few popular Leveraged ETFs:

QLD
DDM
SSO
MVV
SAA
UWM

If you would like to learn more about leveraged ETFs visit my home page http://etfupdater.com or http://proshares.com.

Mike Matousek, CMT
Portfolio Manager, ETF Updater
http://etfupdater.com

How ETF Sector Rotation Strategies Can Outperform the Market

It seems with latest buzz about ETFs and the ease of trading individual sectors within an index, sector rotation strategies are becoming increasingly popular. So the question I’m frequently asked is “how can your sector rotation strategy increase the odds of outperforming the market?”

The answer is quite simple. A positive outlook for the economy surely helps the broad market, but many times during the economic cycle some sectors will outperform the market and respond more favorably than others due to various external factors. The intent of a sector rotation strategy is to increase exposure to the sectors anticipated to outperform and reduce exposure to the sectors anticipated to remain flat or under perform. In doing so, the portfolio manager can capitalize on market fluctuations with the opportunity to benefit from sector expansions and sidestep sector declines.

Keep in mind there are many ways to formulate a sector rotation strategy. Here are the most popular:

Technical Analysis, the analysis of price action, trend lines or other quantitative factors enabling technical analysts quantify a trend change

Top-down Analysis, the theory that changes in the economy can signal imminent changes in sector movement

Fundamental Analysis, the approach of evaluating company financials within a specific sector

Therefore, if a portfolio manager monitors the general health of the economy, the various external factors that have the ability to drive a specific sector and has a solid money management strategy they have a good opportunity to outperform the broad market.

To learn more about the sector rotation strategy I employ for my clients or how we swing trade visit my website http://www.etfupdater.com/

Mike Matousek, CMT
Portfolio Manager, ETF Updater
http://www.etfupdater.com/

ETF Swing Trading – Hedging The Portfolio

I’m a trend trader and trend traders tend to weight their portfolios more heavily in the same direction of the trend. Unfortunately, when trading trends, the portfolio tends to give back unrealized profits during counter trend moves, so to mitigate our drawdown I hedge the portfolio.

For example, say there is a firm called Capital ETF Management, it is near the end of the quarter and the ETF Portfolio Manager deems a correction is imminent. He wants to secure some unrealized gains instead of buying ETF options or liquidating positions.

The money manager calls M1 Consulting LLC (that is my consultancy) and they engage us for additional insight as to how they can reduce risk should a correction occur. Capital ETF Management has a portfolio consisting of the following Exchange Traded Funds a Wisconsin ETF, Copper ETF, Alternate Energy ETF, Wilshire 5000 ETF, China ETF, Precious Metal ETF, Brazil ETF and an Emerging Market ETF.

How would I approach the scenario?

First, I need to determine what security has a near perfect correlation to the portfolio (keep in mind this could be a few different securities depending on the portfolios composition).

After further analysis, we realize the Capital ETF Management portfolio has a near perfect correlation with a Profund’s ETF.

Now I can:

Calculate the estimated volatility of the portfolio
Calculate the estimated volatility of the Profund’s ETF being used as a hedge
Determine when the hedge should be put on
Determine when the hedge should be taken

Note: This should all be calculated and determined before the hedge is put on.

Once I calculate the volatility for the portfolio and the ETF being used a hedge I can determine how many shares must be purchased or sold to put the hedge on.

To learn more about hedging or for more swing trading education visit us at http://etfupdater.com/freeinformation

Mike Matousek, CMT
Portfolio Manager for ETF Updater
http://www.etfupdater.com/

Consumer Staples ETF (XLP) – Sector Rotation

There is a saying the smartest minds work on Wall Street. I’m sure many people agree and want to follow the “professional” opinions they read or hear, but with all of the misinformation, opinion changing and ulterior motives I’m been asked, “how do you know what to do”?

The answer is simple. Sure, I read other opinions about the market, but I don’t act on them unless the market’s price action corresponds with idea behind the opinion. For example, many of the “professionals” are talking about a recession or possible depression. One went as far as saying this is the worst since the great depression. Now, I don’t know if he is correct, but I do know this, the Consumer Staples ETF (XLP) is composed of defensive companies. This means, the companies in the index make products people should be buying regardless of the health of the economy.

For example, here are a few companies in the index as of 11/15/07″

Procter & Gamble Co. PG

Altria Group Inc. MO

Wal-Mart Stores Inc. WMT

Coca-Cola Co. KO

CVS Caremark Corp. CVS

PepsiCo Inc. PEP

Kraft Foods Inc. Cl A KFT

Colgate-Palmolive Co. CL

I bet you purchase many of the products produced by these companies or shop with them regularly.

I run a model portfolio at ETF Updater called the “Sector Rotator”. It seeks to outperform the S&P 500 and just before I wrote the post we liquidated the Industrials ETF (XLI) and replaced it with the Consumer Staples ETF (XLP). I’m not pumping the Consumer Staples ETF for investors or Swing Traders, I’m disclosing I do have a position in XLP.

If you would like more ETF Education, Swing Trading Lessons or would like to know when we make changes to our Sector Rotator portfolio visit us at http://www.etfupdater.com/.

Mike Matousek, CMT
Portfolio Manager, ETF Updater
http://www.etfupdater.com/