UYG - UYG Is An Ambiguous Proposition Unwise Due To It Being A Leveraged ETF

Summary

• UYG is a leveraged ETF that covers a bunch of financial stocks whose exposures, while probably net positive, are mixed to the more stubborn than expected inflation.
• Leveraged ETFs carry a lot of risks and don't make sense for sectors that may require a buy-and-hold logic.
• While some of UYG's holdings are going to benefit from even higher rates, others won't, so this play isn't sharp enough to justify the leverage risk.

The ProShares Ultra Financials ( UYG ) is a leveraged ETF that follows the Dow Jones Financials Index ( DJUSFN ) with 2x daily resetting leverage. Leveraged ETFs come with a host of risks, but they can make sense to hold for burst periods when there's a sharp, near term catalyst involved. Macro conditions unfortunately don't paint a super clear picture for the outlook of financials. Therefore, there's no reason to dabble with UYG, since the higher-rate environment isn't a slam-dunk for it. Pass.

Leveraged ETFs

Be aware of risks on leveraged ETFs. The UYG takes whatever return the DJUSFN does and then multiplies it by two, and produces at the close of day 2x whatever the daily return was for the DJUSFN, day in and day out.

The problem is that while a market index can take a 6% hit and make it mostly back the next day by rebounding 5% or 6% again, the UYG would be going down 10% the first day, and because it's on a smaller base for the next day, would need much more of a rebound of the underlying index to make it back to square one. If your position goes down 25%, you'd need 33% returns thereafter to breakeven, and with a 33% hit you'd need a 50% rebound and so on. Where the DJUSFN might fluctuate, the UYG could be permanently losing value. Indeed, these leveraged ETFs often have this vanishing effect, even if the underlying index made net progress upwards, because of how they respond to volatility.

To effectively use a leveraged ETF, you need to be betting on more days in the right direction than the wrong one for your bet, and you can't be invested with a buy-and-hold horizon.

UYG Breakdown

UYG is a bet on the underlying elements which include stocks like Berkshire Hathaway ( BRK.A ), the full-service financial banks, and payment processing companies like Mastercard ( MA ) and Visa ( V ).

The macro climate is the following: rates appear to be going higher, with the yield curve shifting up again. Inflation is definitely easing , and we haven't even lapped the invasion figures. The issue is the hawkishness coming out of the Fed, and to an extent it is justified. Sequential inflation is still coming in, and jobless claims remain really low, more or less unaffected by the rate actions. If there's really any inflation at all above the 2% mark, if it's allowed to stay too long, or there's any indication that it can't be reduced, households will react and start thinking that's the new baseline inflation figure, and then it will actually become the new inflation figure. Several FOMC members have since spoken about the figures, and the tone is hawkish, and the concerns around inflation impact longer-term rate expectations hence the upward shift in the yield curve.

While some companies like BRK may benefit in their insurance businesses, their asset portfolio cannot hide in a higher rate environment. Also any business levered to volumes of economic activity like V and MA are also going to be exposed to a recession. Finally, banks have the issue that while high rates initially mean better lending dynamics, they'll have to pay more for deposits and loan growth may slow which is so important to retail banking in particular. DCM and corporate banking has already taken the hit in 2022.

Bottom Line

When there's no clear line for upside there's no reason to take a leveraged ETF bet. Expense ratios are high at almost 1%, and the tendency of vanishing value is a risk to take if you fail to time things and try to wait near-term headwinds out. The angle isn't sharp enough so it's best to stay away.

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