Financial Innovation Run Amok

05/24/2017 11:34 am ET

The past couple of weeks has certainly been an interesting time for financial market participants. While political uncertainties -- both domestic and global -- have dominated the headlines, a recent announcement went virtually unnoticed. On May 3rd, the SEC seemingly gave the green light to two quadruple-leverage ETFs offered by ForceShares.

The ForceShares Daily 4X Market Futures Long Fund is designed to provide the "investor" with four times the daily market performance of the S&P 500 Index. The Daily 4X Market Short Fund is designed to produce four times the inverse of the daily market performance of the S&P 500.

I put investor in quotation marks because these aren't instruments appropriate for investors but are wildly speculative and inappropriate for the vast majority of market participants. Proponents contend they are indeed appropriate for professional investors and that the risks are clearly laid out. Leverage ETFs may not be weapons of mass destruction, but in the wrong hands they are vehicles capable of significant wealth destruction. Just last week the 3X Long Brazil Fund suffered a 48.3 percent decline – in a single day. The clear and present danger is that do-it-yourself (DIY) investors who find themselves behind on their savings goals may swing for the fences with highly leveraged ETFs. Berkshire Hathaway Vice Chairman Charlie Munger once said that “Three things ruin people: drugs, liquor and leverage.”

An enormous problem with DIY investing is that many believe that success requires one to trade frequently and employ leverage to outfox the market in the short-run. Leverage ETFs are marketed as a way to achieve both leverage and trade in and out of the market frequently, two prime recipes for underperformance.

The philosophy of activity is reinforced by the short-term focus of 24/7 financial news networks. Earlier this month the obsession was positioning your portfolio for the French election. Before that, it was Brexit. That is all forgotten and the new concern is political turmoil in the United States.

At the 2000 Berkshire Hathaway Annual Meeting (also known at Woodstock for Capitalists), Munger introduced the concept of "Sit on your ass investing." Munger's contention is that one should to identify a few outstanding companies, buy them, and hold them forever. You should only buy a stock if you are willing to hold for an extended period of time, say ten years. Warren Buffett has modified the concept by indicating that he is a fan of index investing for the masses. That is, most investors can skip the step of selecting good companies and simply buy low-cost index funds and be content with market returns over the long run.

In the 1934 investment classic, Security Analysis, Benjamin Graham and David Dodd described the difference between investing and speculation as “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” The current investing public would be wise to revisit this advice provided 82 years ago. A four times leverage fund is so far removed from a quality investment that Graham and Dodd couldn't have imagined such a financial instrument would be available.

Thankfully, the SEC this past week recaptured some sanity and indicated they would reconsider approving the four times leverage instruments. Now if only they would revisit the three times leverage funds.

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