Lottery Ticket ETFs Flourish

Leveraged and inverse ETF trading tools can be dangerous if in the wrong hands.

[ETF Pulse appears Mondays and Thursdays. Drew Voros is Editor-in-Chief of ETF.com.]

We’ve all heard that it takes the right tool for the job, but we don’t hear as much about the wrong tool for the job.

The wrong tool for the job doesn’t always mean the job doesn’t get done or done well. Using a flamethrower to melt snow in the driveway instead of shoveling is a possible solution, but it likely won’t end well on a longer-term basis.

You wouldn’t send your kids out to use a flamethrower to melt the snow on the driveway—hopefully. They will eventually get burned, or, in the best case scenario, the bushes or the car in the driveway will be singed.

That’s much like leveraged and inverse ETFs, which are having a very good year in terms of demand, for the right and wrong (and possibly naive) reasons. And no doubt many are being burned.

Lottery Tickets & Trading Tools

This past week there was a confluence of events around leveraged and inverse ETFs, which tend to lay low and pop their heads out of the ground in seemingly random but actually explainable events, such as back in the beginning days of COVID in March 2020. Demand is triggered by volatility, or the other way around—it depends.

But those events got me thinking about some of the wrong tools in the wrong hands in the ETF world.

Leveraged and inverse ETFs can be effective trading tools for investment professionals, a lottery ticket for someone who walks in at the right moment, and a flamethrower burning those who stay too long because they have no idea what they're doing.

From ETF.com’s Jessica Ferringer’s reporting this week:

“… money flowed into the ProShares UltraPro QQQ (TQQQ), which offers 300% exposure to the Nasdaq-100 Index. On the flip side, the ProShares UltraPro Short QQQ (SQQQ), which offers the opposite exposure of TQQQ, or -300% of the performance of the Nasdaq-100 Index, saw net outflows for the week.” (Read: Leveraged ETFs Don’t Always Deliver)

Right Tool For The Job

Good use of tools to do the right job here. Tech is getting roiled, as is the market, and the short game is on. The Invesco QQQ Trust (QQQ) is reflecting the fallout, as it should, and this seems like the way the game is played, with traders moving in for a potential quick kill if things work their way.  

To me, these products are proper tools if they’re in the hands of professional traders. But the retail investors caught up in the asset tide most likely won’t fare well for reasons below.

Inverse ETFs are seeing brisk business this year. Their assets under management are up 43%, reflecting concerns around a market at all-time highs and the hedging that's a natural outgrowth of those highs. 

Leveraged ETFs have seen their AUMs increase 6%. Together, leveraged and inverse ETFs have pulled in nearly $10 billion in new assets under management.

Dangerous Tools

Most recently, we've seen ETF Managers Group complete its suite of marijuana ETFs, which includes 2x and -2x exposures to the underlying index of the ETFMG Alternative Harvest ETF (MJ), which has $10.5 billion in assets and comes with a heavy 0.75% expense ratio.

The ETFMG 2x Daily Inverse Alternative Harvest ETF (MJIN)  launched Wednesday, joining the ETFMG 2X Daily Alternative Harvest ETF (MJXL), which launched in July and now has $544K in assets, with an expense ratio of 0.95%.  Investors now have all the tools they need to play the marijuana space, though the risks that come with MJIN and MJXL are considerable.

SEC Adds To Confusion

On Monday, SEC Chair Gary Gensler ordered a review of leveraged and inverse exchange-traded products even as the Cheech (MJIN) of these kinds of products snuck in two days later to join its Chong (MJXL).

“This week, I directed staff of the Securities and Exchange Commission to study the potential risks of complex financial products that are listed and traded on exchanges….  I also asked them to present recommendations for the Commission’s consideration on potential rulemaking proposals to address those risks, as part of a broader look at exchange-traded products (“ETPs”) (Statement on Complex Exchange-Traded Products).

Leveraged and inverse ETFs have been extensively reviewed. The first ones were launched before the Great Financial Crisis under the Bush II administration, and the SEC has been freaking out about them ever since.

That’s why there have been all kinds of reviews and investigations into these products. You know … once bitten, twice shy and how that’s why they’re taking so long to approve a bitcoin ETF.

As a result, the SEC can't walk back leveraged and inverse ETFs and have been patching things with Band-aid solutions, like limiting who could launch leveraged/inverse ETFs and banning any future 3x ETFs. 

SEC Regrets

The SEC is having flashbacks to the disastrous outcomes many experienced with the first leveraged/inverse ETFs. And that’s why it's being extra cautious with crypto ETFs—it can’t put the genie back in the bottle if things go wrong.

Lost in the shuffle is the word “education.” The SEC doesn’t use that word much until investors start struggling, like with basic math of leveraged and inverse ETFs. Math is hard.

From Ferringer’s ETF.com story:

“Investors who purchase leveraged ETFs should be fully aware that if these funds are held for longer than a few days, they might not be getting the exposure they expect—both directionally and in magnitude … leveraged funds provide the potential for higher gains if one correctly predicts the way the market will move over the next few days. But as with anything in the investing world, this promise of higher reward also comes with a higher level of risk. If the market moves against you (and sometimes even if it doesn’t), investors can get burned.”

Reach into the ETF toolbox carefully. Bring a calculator.

Drew Voros can be reached at [email protected].