Fool Me 4x

Posted On May 3, 2017 2:22 pm

When word came down after the close yesterday that after an initial delay the Securities Exchange Commission had approved the listing of two Exchange Traded Funds (ETFs) employing 4x leverage, the response ranged from applause, to concern, to ridicule, and of course the internet being what it is, ridicule.

Honestly, when I first read the news my first thought went to humor site The Onion’s article from few years ago titled F*ck Everything, We’re Doing Five Blades which mocked the razor blade ‘arms race.’ But we can get to the funny stuff later. First the facts.

The two new ETFs are to be marketed and managed by a little known company operating under the name Forceshares Trust, a subsidiary of New Jersey based ETF Managers Capital LLC.

The two ETFs are to be called ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund, trading under the proposed symbols “UP” and “DOWN”.

As the tickers suggest, one of the funds is designed to deliver 400 percent of the daily performance of S&P 500 stock index futures, while another fund will aim to deliver four times the inverse of that benchmark. That means – in theory – a fund could go up 8% on a day if the index it tracks falls by 2%.

Sounds great, with many active traders applauding the new toy. But for many in the industry, or those who don’t understand why just doing four times as many shares or using the existing a 2x or 3x leveraged products, such as ProShares Ultrashort (SHO), don’t suffice, the approval seemed a poor decision on the SEC’s part.

The problem is the structure of these leveraged products, which get ‘reset’ every day, creating a tremendous headwind driving their value inexorably lower over time. These products are not only totally inappropriate for unsophisticated retail traders who don’t understand the nuances of the pricing behavior and often misapply them, but it can also create dangerous imbalances by large funds looking to exploit them.

As we’ve seen in several of the volatility based products, such the VXX, which has a price that heads towards zero over time, these will likely be used as another massively shorted vehicle by all hedge and pension funds who capture the volatility roll “dividend” from markets that no longer see any risk, anywhere positions.

These ‘short gamma’ positions are fine in low volatility environments, but if the market starts to decline and volatility picks up, the funds will need scramble to cover which could create a negative feedback loop of the interrelated positions causing another flash crash.

A few of the red flags, including the inexperience of the firm running the funds, was flagged back in January in this article from Themis. It includes:

  • the Sponsor has no experience operating commodity pools
  • the Sponsor is “leanly staffed” and “relies heavily on key personnel to manage trading activities”
  • the success of a Fund depends on the ability of the Sponsor to accurately implement its trading strategies, and any failure to do so could subject the Fund to losses.
  • the Sponsor may have conflicts of interest, which may cause them to favor their own interests to your detriment…the Sponsor’s principals, officers or employees may trade futures and related contracts for their own accounts.
  • the Sponsor has limited capital and may be unable to continue to manage the funds if it sustains continued losses
  • the failure or insolvency of the Custodian for a Fund could result in a substantial loss of the Fund’s assets.
  • the Funds are not registered investment companies, so you do not have the protections of the 1940 Act.

As Themis concluded in January, “There are plenty of questions regarding the specifics of this product but the real question is: does the market really need a 4x leveraged product? If the SEC approves this product, then what is to stop a company from trying to list a 5x, 10x or even 100x leveraged product? ”

Some of the reactions on Twitter:

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.