Are Leveraged ETFs Bad for the Market?

In a letter to options wiz Adam Warner on Minyanville, reader JKW makes some interesting points on leveraged ETFs, which includes the ever popular Direxion FAZ and FAS triple-leveraged flavor:

Among other things, JKW notes that “There's nothing you can do with inverse ETFs that you can't do with puts” and that “Although it might be a good idea to separate them out as a different class of instruments and require explicit permission, extra paperwork and waivers to trade them, like options have. That way, people won't just think that they can buy SSO and leave it for 40 years and expect to get twice the returns of SPY.”

And here’s my former boss at TheStreet.com, Jim Cramer, railing against the UltraShort Financial Proshares (SKF): Says Mr. Cramer: “I think we can go a long way towards shoring up our tattered financial system if the SEC simply banned the SKF, uh that’s a hideous instrument called the UltraShort Financials Proshares. I call it the ETF of mass banking destruction.” In this regard, he was focusing on the impact falling share prices can have on the banking system.

With all this discussion on the wild world of leveraged ETFs, it’s time to ask:

Are leveraged ETFs good or bad for the market?

Like with most complicated questions, the answer is… …MAYBE!

Unlike Jim, I don’t believe the short sellers were particularly at fault for driving down banking stocks. Nobody has produced the data yet, but I’d be willing to bet a vast majority of the declines came from long investors like big mutual funds dumping their stocks on the way down, creating an endless cycle of negativity.

And what about the actual companies? It’s not like these were high quality companies with pristine, or even understandable balance sheets. The shorts can be an convenient scapegoat for failing companies suffering the results of mismanagement.

As far as investors go, we should make the distinction between investors and traders. The leveraged ETFs, including the triple-leveraged Direxion variety, are clearly designed for short-term trading, not long-term investing. Not that any of the traders using these ETFs is paying attention, but this message appears on DirexionShares.com:

Anyone playing with these instruments knows how dangerous they are, and with trading volumes exceeding tens of millions of shares a day, they’re clearly being used as trading vehicles.

Traders using ETFs like the FAS and FAZ are looking to make short-term bets and they are well aware of just how quickly they can lose. One could easily get in just as much trouble trading options, futures, or currencies. So why is there no outrage over 100 to 1 leveraged currency trading? Or naked shorting of puts and calls?

JKW may be on the right track with the idea of having investors fill out extra paperwork with their brokerage firm saying they fully understand the risks of playing with leveraged ETFs. But then again, how many people actually read the CBOE’s Characteristics and Risks of Standardized Options document which is required to open an options account?

The real question quickly becomes, how much should regulatory bodies protect people from themselves? When it comes to leveraged ETFs, they shouldn’t bother, because people who want to gamble will always find a way. If it’s not wacky ETFs, it will be something else. You can’t stop people from wanting a quick buck.

I’ll end with this quote from Chris Rock. Just substitute ‘ETFs’ for the drugs:

People love to get high. You could get rid of all the illegal drugs in the world and it won't mean sh*t. People want to get high. You could get rid of all the crack, all the herb, all the blow, you know what would happen? People will just think of new ways of getting high. That's right, guys would go into their basements and become scientists. 'Like dude, check this out, check this out, you know, if you get a baby's bottle, and you fill it up with a little gasoline and dead lima beans, and you suck it, you'll be f*cked up!'

What do you guys think – are leveraged ETFs good or bad for the market? Post a comment below.