Best ETF Strategy: Avoid 4X Leveraged ETFs like the Plague

Best ETF Strategy: Avoid Super Leveraged ETFs

Updated July 1, 2024

Introduction:

The allure of leveraged ETFs, such as the recently introduced 4X ETFs, centres on their promise to significantly amplify the daily returns of an index, potentially leading to substantial financial gains. However, the risks associated with these high-leverage products are considerable, often resulting in outcomes that can severely undermine long-term investment goals. This essay delves into the perils of 4X ETFs and contrasts them with safer, more sustainable investment strategies using traditional ETFs. By exploring the benefits of best ETF strategies, including diversification, enhanced indexing, and strategic use of options, we aim to provide a roadmap for investors seeking robust returns without the dire risks associated with excessive leverage.

Understanding 4X ETFs: Mechanisms and Risks

4X ETFs are designed to offer four times the daily performance of their underlying index. If the index rises or falls by 1%, the 4X ETF aims to increase or fall by 4%. While this can lead to significant gains during favourable market conditions, it also poses substantial risks during downturns. The Bank of Montreal’s Max SPX 500 4x leveraged ETNs, based on the S&P 500 Total Return Index, exemplify such products, structured as Exchange Traded Notes (ETNs). Unlike traditional ETFs, ETNs carry additional credit risks, as they are unsecured debt notes issued by financial institutions.

The volatility of 4X ETFs is a significant concern. Their performance can significantly deviate from the intended fourfold return over extended periods, especially in volatile markets. This is due primarily to their daily leverage reset, which can compound losses rapidly during downturns. Consequently, these instruments are recommended only for experienced traders who can manage short-term positions. The prospectus from BMO stresses that these products are unsuitable for long-term investment strategies or investors with a ‘buy and hold’ approach.

Best ETF Strategies for Long-Term Investment Success

Investors seeking sustainable returns with moderated risk might consider more conventional ETFs, which offer diversified exposure without the extreme risks associated with leveraged products. Strategies such as long-term holding and enhanced indexing can provide substantial returns and are endorsed by financial experts.

Diversification is essential, allowing investors to spread their investments across various sectors and geographies and mitigating risk. Renowned investor Warren Buffett has long advocated using S&P 500 index ETFs for consistent, long-term capital growth. Enhanced indexing, another effective strategy, involves slightly modifying the standard indexing approach to potentially outperform market benchmarks. For instance, ETFs that focus on value, such as the Vanguard Value ETF, aim to track indices that measure the investment return of large-cap value stocks.

Options can also be integrated with ETF investments to enhance returns and protect the downside. Lawrence G. McMillan, a noted options strategist, suggests strategies like selling covered calls on owned ETFs to generate income or buying puts as insurance against declines.

Incorporating technical analysis and understanding mass psychology can further refine these strategies. Analyzing market trends and investor behaviour can identify optimal times to adjust ETF holdings, potentially enhancing returns while managing risks. For example, technical indicators such as the Relative Strength Index (RSI) can signal when the market is overbought or oversold, providing insights into when to buy or sell.

Historical Context and Regulatory Concerns:
Launching 4X leveraged products is not without precedent; however, regulatory bodies have been cautious. In 2017, the SEC approved similar products but quickly retracted the decision, signalling concerns about the risks associated with high leverage. These regulatory hesitations underscore these financial instruments’ potential dangers to individual investors.

Best ETF Strategies for Sustainable High Returns

Investing in ETFs (Exchange Traded Funds) can be an excellent way to achieve high returns without exposing oneself to the excessive risks associated with leveraged products like 4X ETFs. Noted financial experts recommend several strategies that utilize ETFs to maximize returns while managing risk effectively.

Diversification and Long-Term Holding
Diversifying across various sectors and geographic regions is one of the safest and most effective strategies in ETF investing. This approach spreads out potential risks and taps into different economic cycles. For instance, Warren Buffett, the CEO of Berkshire Hathaway, often emphasizes the value of diversified, long-term holdings. He advocates for the S&P 500 index ETFs as a reliable investment for consistent growth over time, reflecting the overall market performance without frequent trading.

Enhanced Indexing
Another strategy is enhanced indexing, which involves using ETFs that attempt to slightly outperform index benchmarks. This can be achieved through minor adjustments to the index strategy based on factors such as value, size, or momentum. For example, Vanguard’s Value ETF (VTV) seeks to track the performance of the CRSP US Large Cap Value Index, which provides exposure to large U.S. companies that are considered undervalued compared to their peers.

Utilizing Options for Income and Protection
Experts like Lawrence G. McMillan, author of “Options as a Strategic Investment,” suggest using options with ETFs to generate income or protect against downside risk. Selling covered calls on ETFs you own can provide additional income and some downside protection. Conversely, buying protective puts can help safeguard your ETF holdings against significant losses, acting as insurance.

Strategic Use of Technical Analysis and Mass Psychology

Combining ETF strategies with technical analysis and understanding mass psychology can enhance returns. Technical analysis tools like moving averages or MACD (Moving Average Convergence Divergence) can help identify trends and potential reversal points in ETF prices. Additionally, understanding investor sentiment and behaviour can provide clues about market tops or bottoms, enabling more informed decisions about when to buy or sell ETFs.

For example, when fear is pervasive during market corrections and ETF prices may be undervalued, technical indicators might show oversold conditions. Purchasing ETFs during these times can lead to significant gains as markets normalize. Conversely, when ETFs might be overbought during market euphoria, taking profits or implementing protective strategies could be prudent.

Safer Alternatives for High Gains:

Traditional long-term ETFs provide a viable alternative for investors seeking substantial returns without excessive risk. These funds offer exposure to various asset classes without the risks associated with leveraged products. Additionally, sophisticated strategies such as selling puts to finance the purchase of calls can achieve leverage in a more controlled manner, potentially increasing returns without the disproportionate risk of 4X ETFs.

Leveraging Mass Psychology and Technical Analysis:

Investment strategies that leverage mass psychology and technical analysis can significantly enhance returns without the need for excessive financial leverage. Investors can identify optimal entry and exit points by understanding market sentiment and employing technical indicators like the Relative Strength Index (RSI). This approach allows for capitalizing on market inefficiencies and emotional extremes, which can be more predictable and less risky than relying on leveraged products.

Conclusion

The optimal moment for contrarian investors to acquire leveraged ETFs often arises after a stock market crash or significant correction. During these periods, the masses panic, metaphorically “throwing the baby out with the bathwater.” Like lemmings, they seem to forget that this pattern has repeated throughout history, mirroring the actions of their forebears. Thus, the cycle of market overreaction persists, presenting opportunities for the astute investor.

By employing these ETF strategies, investors can achieve substantial returns while maintaining a lower risk profile than highly leveraged products. The key is to combine sound investment principles with strategic use of options and technical analysis, underpinned by a thorough understanding of market psychology.

While 4X ETFs offer the potential for rapid gains, their associated risks and volatility make them unsuitable for most investors. Traditional ETF strategies provide a safer, more reliable path to financial growth. By adopting a diversified approach, leveraging options for income and protection, and utilizing technical analysis, investors can enjoy substantial returns without the dangerous risks of high leverage. This balanced approach to investing aligns with long-term financial goals and ensures a more stable and secure investment portfolio.