Geared Gambling with ETBs

One of the fastest growing segments of the investment industry has been the market for exchange-traded funds (ETFs). According to the Investment Company Institute, the ETF market had over 1375 funds with net assets exceeding $1.8 trillion as of July 2014 (click HERE). More than 5.7 million US households (>5%) own an exchange-traded product. The market for ETFs began in 1993 when State Street launched the S&P 500 index fund (ticker: SPY) with an initial capitalization of $6.6 million. As of today, the SPY fund had more than $190 billion in assets.

As the assets within ETFs ballooned, the number of new products offered by Wall Street rapidly expanded beyond passively managed low-fee equity index offerings. Over time, companies such as Direxion, VelocityShares, and ProShares introduced leveraged and inverse betting tools that promised multiples (2x, 3x, etc.) and negative multiples (-2x, -3x, etc.) of the index or benchmark they tracked.

So What? I believe these leveraged and inverse products are better thought of as gambling products rather than investment vehicles. The main reason I say so is they promise multiples and negative multiples of the daily performance of a particular index, creating wildly divergent performance from an unsophisticated buyer’s expectations—at much higher fees! (click HERE for more). Who other than gamblers care about the daily move in a particular investment opportunity? Surely no serious investor expects to profitably bet on one-day moves, which are often statistically random.

Consider the chart below, which I think tells the story. Over the past year, GLD (exchange-traded gold) rose by 2%. Had you invested in the 3x leveraged gold product (UGLD), you would have lost 1% (vs. the expected +6%). And had you invested in the -3x inverse gold product (DGLD), you would have lost ~18% (vs. the expected -6%). That’s right, it didn’t matter if you were bullish or bearish, you lost money playing the inverse or leveraged game! Further, both DGLD and UGLD charge investors a 1.35% investment fee, versus the 0.40% expense ratio for GLD, a meaningful difference in a world of extremely low interest rates.

When I see something that has feathers, webbed feet, enjoys water, and quacks, I call it a duck. Perhaps the time has come for regulators to mandate that these products be called what they actual are: exchange traded bets (ETBs). What’s next? Wynn Resorts to offer the Emerging Markets 20x Bull ETB? Or perhaps the Asian Luxury Consumer 40x ETB sponsored by Las Vegas Sands?