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Morning Star
January 27, 2009
Paul Justice: Hi I’m Paul Justice ETF Strategist with Morning Star. Today I am joined by Bradley Kay ETF Analyst and we are here today to talk to you and raise some awareness about certain ETF products—leverage ETF’s and I want to give you a big warning a lot of people do not know how this work. They are using them as long term holdings there is an obvious short fall as to the structure these funds. They do not work over long periods of time for most people. So we want to dive into that and raise some awareness on this campaign. Let’s look at some that is less volatile—the SMP500. We know that was down about 40% last year. How did the leverage and in first funds work in that case?
Bradley Kay: When you have much less volatility, you actually end up still not tracking perfectly but you end up with directionally correct movements so by the end of 2008, you ended up with the and first fund actually had done about right and it ended up about 35% up to very close. But there are still some factors, which call these to under perform what you would expect for the year, and so the beat way to imagine it is that the SMP500 is around 900 at the moment.
If you picture it loosing 10%, it goes down to a 10 but what quite often happens is you do not get a 10% movement up instead, you get a movement that makes up what we lost. So we can go back to say 900. That’s just some meaner version that you tend to see in some of the returns but that is a movement actually of 11% from the level of 810 so over that period when you’ve gone down and then back up, you have lost 10% and gained 11%. Your in first fund would have gained 10% and then lose 11% and so you would have done worse on the upside and better on the downside. You have ended up actually exasperating that difference in returns that you would end up with. You would end up with a an ever growing gap and so we see that on inverse funds and that is the reason why they perpetually not by too much but they do consistently under perform what we would expect—
Paul Justice: Now a proponent of inversed in leverage funds, they’ll throw out a few arguments of one with the inversed funds lets say. You can only loss the amount of money that you put out on the table where as they will state that if you’re short of stock, you’re losses are potentially infinite.
Bradley Kay: That’s true and with margin accounts you can be white’s out and you can actually owe money beyond what you originally set aside as your collateral.
Paul Justice: So if I am using these leverage DTF’s and it goes up a considerable amount as long as I take off some money off the table every single day, I can kind of replicate what is going on in the marginal account but for me to reconsider my position every single day and look at that and possibly make a trade every single day. I guess almost by definition I become a day trader essentially.
Bradley Kay: Exactly. They can behave like a marginal account. They can behave like a short but you’re going to bidding up to a lot in trading cost and you have to be sure to monitor your position closely.
Paul Justice: True and with that, I’m Paul Justice, ETF Strategist at Morning Star; thank you Bradley Kay.
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