WEBL - WEBL: Volatility On Volatility With Major Value Erosion Risk

2023-03-27 09:11:57 ET

Summary

• Leveraged ETFs carry major inherent risks. Volatility in the underlying index amplifies that risk even further, and makes value erosion even more likely.
• While a great intraday instrument for making aggressive speculative calls, any extended holding period, especially in this environment, would be very dangerous.
• With the market likely to be a series of relief rallies followed by plunges as the markets try agree on the future with the institutions, WEBL is to be avoided.

The Daily Dow Jones Internet Bull 3X Shares ( WEBL ) tracks an index of pretty large cap technology companies in the US with daily 3x leverage. There are inherent considerations in leveraged ETFs that need to be understood carefully by investors considering these products. In the current environment, and given the underlying index's relative sensitivity to the sort of events that might bring large multiples down a couple pegs further, WEBL is not a good pick unless for highly speculative, intraday trading that takes advantage of the relatively cheap access to leverage.

Careful with Leveraged ETFs!

Because the returns of the ETF are 3x the underlying index on a single day and then reset, there is the possibility of value erosion. If the underlying index declines some percentage points, and then makes it back to its initial levels some days later, investors in the underlying index will not have lost money. Meanwhile, WEBL investors may not be able to make it back to square one with the 3xed daily returns of the underlying index, since downside leverage to a smaller base will require more returns the next day to make it back. The underlying index might decline 4% on 3 consecutive days, compounded to a little bit below a 12% decline, and would only have to compound back 13% returns to get to square one, barely suffering from the lower base effect. If you could employ leverage over whatever period you chose, for the duration of the trade, you'd be mostly fine as well. On the other hand, WEBL over that same period because of its 3x daily leverage would have to compound back 46% returns to get back to square one. That would require some very strong and uninterrupted series of good days to make it back. With random walk dynamics, these disadvantages of the lower-base effect compound and you get value erosion.

This value erosion effect is something speculators need to consider very carefully, and it means that leveraged ETFs are best suited for short periods and speculating even intraday. The expense ratios are quite low on these ETFs meaning it's a cheap way to access leverage, but this value effect is a major issue.

Be very wary of leveraged ETFs, and here are some more authoritative links for reference on these risks:

• The Lowdown on Leveraged and Inverse Exchange-Traded Products
• Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors
• Regulatory Notice 09-31 | FINRA.org

Volatility on Volatility

Housekeeping aside, the issues with leveraged ETFs are more pronounced with an ETF like WEBL because the underlying index is composed of high multiple, high value tech stocks like Amazon ( AMZN ) and Google ( GOOG ). A lot of expectations are riding on these stocks because of their high multiples, and in an environment where costs of capital are mounting, there is more risk to these high multiple stocks as the gravity of interest rates starts to pose a problem for them. In particular, the expectations for many of these stocks are associated with cloud revenues, which already saw slight deceleration and may experience more hits to their sales velocity even though the secular picture remains pretty good.

With the underlying index capable of producing more sensitive daily returns already, and with expectations high in a market that continues to set itself up for disappointment with the actions of the Fed, meaning there's more downside risk than upside risk, there is more than just the problem that we are in a down market . Daily leverage in these ETFs are likely to lead to some permanent value erosion as markets continue to be slow on the uptake as far as the echoes of any banking instability goes, even where the crisis is averted, and how likely the Fed is to continue to focus on inflation at the expense of the economy, as they always have said they will, despite their dual mandate.

Expense ratios are pretty low annualizing at 1% per year. This means that you get access to leverage for a pretty cheap price compared to the costs of margin. However, the benefits come at smaller costs if trading periods are short, and the use of the instrument is focused on speculative ideas. This is really not meant for long-term holding at all, and indeed will be pretty disadvantaged in performing well over long-term periods. Even over shorter periods, we don't expect the near term to be better more than worse for markets, and if we did we would not play this with a leveraged ETF. As such, WEBL is a pass.

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