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The Anti-Leveraged ETF


Mutual funds and convertibles to watch.

Two of my recent themes have been the longer-term benefits of convertible bonds and the misleading traps of leveraged ETFs. Just as Reese's hit upon a magic combination of 2 standalone winners with its peanut butter cups, I am going to ask Minyans to consider putting these notions together and swapping out of leveraged ETF's into convertibles.

With leveraged ETF's, as we have shown and as the "manufacturers" themselves concede, a volatile market is your biggest enemy. Remember that the funds are designed to produce double, or double in the opposite direction, of the underlying index's daily return. Just remember this example:

Index ABC goes up 25% first day, down 20% the next. Index ABC itself for the two days is unchanged-this fact itself is not particularly intuitive, but tremendously important, and highlights both the value of steady positive returns and by implication the difficulty in generating them.

Ok, index ABC is unchanged over our hypothetical 2-day period. What happens to a leveraged ETF designed to track ABC?

The first day, it goes up 50%. Let's make the math transparent and say it goes from 100 to 150. (We can of course call the starting point whatever we want). The next day, it falls 40%. 40% of 150 is 60 points, leaving the ETF at 90, down 10% for the period.

This example should be enough to convince you of how brief your holding period needs to be in these trades. As people become increasingly aware of the need to unwind daily, the likelihood of tracking error, and lower returns, may increase. "Get out or look out" is the market-on-close mantra.

In convertibles, we used to have the pair of sayings, "they go ex (dividend) every day" and "you get paid to wait." For the uninitiated, the idea was that your holdings gradually accrued interest, regardless of what the stock might be doing any given day.

You're never freed from your own decision-making, and you only end up getting your interest payments if the company in which you invest remains solvent. But now, more than ever, it's critical to distinguish between assets of finite life (bonds) and those of essentially infinite duration (stocks).
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No positions in stocks mentioned.

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