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The Market's Recent Near-Death Is Hindering the Use of Inverse and Enhanced ETFs

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Knowing how powerful these ETFs are might make you want to use them, not use them, or use them sparingly.

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MINYANVILLE ORIGINAL I worked at Lehman Brothers. Like many people, I thought the firm was omnipotent, and that it might get into trouble, but that it would never die. When the firm collapsed, I was in shock, along with most of the financial world. That shock can be felt to this day. Although it has not made cowards of us all, it has contributed to reducing people's risk appetite. Lower institutional volume coupled with individual investors shunning the market in droves show that risk aversion continues.

In the Lehman collapse and other near-death experiences (such as the Bear Stearns bankruptcy and the freeze-up of the auction rate securities market), there was a realization that the financial system could actually shut down. No generation of investors has seen this since the market crash in 1929. Not only did stock and bond investors get hurt, but those who had "safe" fixed-income investments that paid a little more than money-market funds got hurt as well. Investors were surprised to see that they had been taking on a lot greater risk than they had thought.

Because of the shock, you hear things such as, "Stay away from anything having to do with derivatives, leverage, inverse, and margin." This has kept some investors from using some effective investing and trading tools, tools that can lower risk, increase profit, and otherwise change the complexion of portfolios and fine-tune investment strategies.

Using Leveraged and Inverse ETFs.

Inverse and leveraged ETFs are effective tools for traders and investors. These securities can also cause great harm if not used the right way, so it is important that investors understand what these ETFs are structured to do.

With the backdrop of the Lehman Brothers meltdown and the fear that something like that could happen again, we also are exposed to the widely publicized bad experiences of traders and investors who did not totally understand inverse and leveraged ETFs. This has added to the aversion to using them. There are also other securities that are subject to risk aversion caused by misunderstanding, such as leveraged closed-end funds, both taxable and tax-free, structured market-linked CDs, commodity exchange traded notes (or ETNs), and others.

Adding to the confusion is that things that sound like ETFs are not ETFs, such as ETNs. ETNs are different than ETFs. One of the major differences is that holders of ETNs usually have credit risk. This means that if the ETN maker, which is usually a major bank or other financial institution, goes broke, the ETN holder could lose all or part of his or her investment. Because of their structure, regular ETFs hold the actual securities of the indexes they are replicating, whereas ETNs usually hold futures and derivatives, and are structured to return the performance of a commodity or benchmark, not replicate an index, as an ETF is constructed to do.

Risks and Rewards.

For those who take the time to understand the nuances of how inverse and enhanced ETFs work, the securities can be powerful tools to use for hedging as well as speculating on market long-term and short-term moves. Long-term investors with a buy-and-hold strategy would use these securities differently than a trader. A long-term investor using them should have a clear purpose in mind, and have a time horizon to be long the securities and then sell them.
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The author's clients own TZA.
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