Financial websites (including ours) are rife with warnings about the dangers of leveraged exchange-traded funds (ETFs) and exchange-traded notes (ETNs). We’ve often pointed out the problems with these 2x and 3x funds — including the fact that they’re often marketed to the kinds of investors who shouldn’t be delving in them at all.
But leveraged ETFs can be a great tactical tool, too — if you know what you’re doing.
So, if you’re interested in the prospects of “double” or “triple” returns — and most people are — read on, and we’ll talk about when it makes sense to use leveraged ETFs, and how to do so responsibly.
If You Want to Invest, Invest
When you invest, you put your money into some sort of asset with the reasonable expectation that it should appreciate over time. Maybe you think a company’s products have promise, or maybe you simply think the company is undervalued, and that eventually, other investors will get wise and bid the stock higher.
But when you invest, you also do so with the thought that there’s some downside protection. Companies wish tangible assets are at least worth something, and companies with cash aren’t just worth something — they can use that cash to distribute income, which can offset capital losses, or buy back shares to prop up the stock price.
That’s investing.
But many disciplined investors believe in the 60/30/10 Rule, which suggests you be conservative with 60% of your portfolio, moderately aggressive with 30% of it, and very aggressive with just a small portion (10%) of it.
That 10% is where leveraged ETFs come into play.
Sometimes It Pays to Trade Boldly
A great example of an “aggressive” investment? Small-cap biotech stocks — tiny companies whose fates are tied to one or two drugs that haven’t even come out of trial stages yet. Shares will pop on any good news and tank on any bad news as investors search for any indication about whether the company will turn a profit.
But this strategy is more akin to gambling than investing. While we can point to a blue chip’s marketable products, or its cash hoard, we usually have no way of knowing how likely a drug is to pass through trials.
Leveraged ETFs, however, provide the same type of high-risk, high-reward opportunity on an actual investment thesis.
In mid-May, when West Texas Intermediate oil plunged below the $45 mark, I bought into the United States Oil Fund LP (ETF) (NYSEARCA:USO). U.S. firms were shutting down oil rigs left and right to slow production, which in turn was expected to prop up oil prices. I didn’t call a perfect bottom, but I’m not complaining — USO is up some 25%-plus since I bought in, and the fund itself is off more than 30% from its March basement.
And yet, I goofed.
See, the USO buy was simply a swing trade. I never planned on holding USO for very long, because with USO, there’s nothing but oil prices — no company that can help back shares with share repurchases, no income in my pocket. This was a trade from what I considered my “aggressive” allocation. I just made it in a muted manner.
In this instance, I should’ve traded leveraged ETFs instead.
Hindsight is 20/20, but the right play here was the VelocityShares 3X Long Crude Oil ETN (NYSEARCA:UWTI), an ETN that aims to provide triple returns on WTI futures.
The risks are many. Most notably, “triple returns” can mean triple losses, so you only want to allocate a small amount of money toward any one position. And UWTI’s triple returns are on a daily basis — held over a long enough time, you might get far less than that depending on what the index does day to day.
But if you’re trading aggressively and willing to lose most of that money anyway … why not?
In this case, UWTI has returned about 110% from the USO’s bottom, and I would’ve netted 85% gains from when I bought USO.
Bottom Line
What trades call for max aggression comes down to your own personal investing style. For instance, I don’t hold commodities because I don’t believe they provide enough of a real, meaningful hedge to warrant the position, and if I’m going to hold something for an extended period of time, I usually want it to pay a dividend.
But I am willing to trade commodities from time to time for a little extra return. And on that front, investors have a lot of leveraged ETFs to choose from, among them:
- Crude Oil (Short): VelocityShares 3X Inverse Crude Oil ETN (NYSEARCA:DWTI)
- Natural Gas: VelocityShares 3x Long Natural Gas ETN (NYSEARCA:UGAZ)
- Natural Gas (Short): VelocityShares 3x Inverse Natural Gas ETN (NYSEARCA:DGAZ)
- Gold: VelocityShares 3x Long Gold ETN (NASDAQ:UGLD)
- Gold (Short): VelocityShares 3x Inverse Gold ETN (NASDAQ:DGLD)
- Silver: VelocityShares 3x Long Silver ETN (NASDAQ:USLV)
- Silver (Short): VelocityShares 3x Inverse Silver ETN (NASDAQ:DSLV)
And it should be noted that there are plenty of leveraged plays on other assets, from the broader market to gold mining stocks.
Just remember: Leveraged ETFs should be handled with care, but if you’re a risk-tolerant investor looking for a high-reward play, they can be one of the most effective tools in your toolbelt.
Kyle Woodley is the Managing Editor of InvestorPlace.com. As of this writing, he was long USO, but was considering exiting the position within the next two weeks. Follow him on Twitter at @KyleWoodley.
