Are leveraged ETFs a threat to the industry?

Jun 18, 2014 @ 12:00 am

Runtime: 6:56

Mark Yusko of Morgan Creek Capital Management addresses the industry backlash against leveraged ETFs, and lays out some of their advantages as investment vehicles.

Video Transcript

[MUSIC] Last month Larry Fink, Chief Executive Officer of Black Rock, said that leveraged ETFs could blow up the industry. And that his firm would never, ever launch a leveraged ETF. Well those comments raised a big debate in the ETF business about these leveraged ETFs. Could they really be used to blow up the industry? And how can they really be used in investment portfolios and should advisors really be paying attention to them? Today, we're joined by Mark Yusko, head of Morgan Creek Capital Management. Mark uses leverage ETFs in some of his portfolios and he's going to talk to us about this issue of leverage. And how they can be used and how advisers can use them in their portfolios. Mark, thanks for joining us today. Thanks for having me. So, this issue of leveraged ETFs came about largely because Larry Fink, CEO of Blackrock. Right. Commented that leveraged ETFs could blow up industry. And first of all, I wanted to ask you what you thought of his comments were they a little bit overboard or is there some grain of truth in there? What do you think? Yeah, look, you know, I think they're a little out there. I don't think were any imminent danger of, of the industry blowing up. I think, you know, the derivative industry broadly speaking. Is, is pretty big. You know, some of the banks have some pretty big derivative exposure, probably worry more about that first. And the ETF space, you know, leverage is a tool. And I think there's a good use of leverage today, and I don't think we're at extremes, but I think there's a kernel of truth to what he's talking about. Okay. Yeah, and certainly leverage is something that's used across the financial industry. Yeah. From ETFs through, you know, even, you know, structured products and things like that. Yeah. So it's not like it's a new concept. And by all of us every day. Right, we have a mortgage on our house. Exactly. We put 20% down four times leveraged. People say, I would never do that with equities. That's right. Do it with the equity in your home. Yeah. So, leverage is just a tool. Right. So can you tell us a little bit then about what are some of the benefits of leverage and then we'll talk about some of the risks. Yeah, so leverage, again it's, it's a tool. It's used to amplify the return of some asset. So if I put 100% down on my house and the price goes up 10%, I make 10%. If I borrow the money, I make 20%. Same thing with an ETF. If I buy an ETF with cash and it goes up 10%, I make 10%. If I borrow half the money. I make 20%. So it, it's a tool that amplifies the return. Now, can amplify the up, and it can amplify the down, so there's one of the risks. And, and how does that work? Tell us a little bit about [INAUDIBLE]. Yeah, so, you know, so, if, if I bought a house with cash and went down 10%, I lose 10%. If I bought a house with half leverage, I lose 20%. Right. If I put no money down, I have infinite downside, right? Yeah. Because I have no equity. Exactly. So it's a long way to call yourself back. So, same thing in an ETF. If you're down 10%, a levered ETF will be down 20. And because of some structural issues, you might even be down a little more because of some rebalancing thing. But, but not dramatically more. Okay. And that was, that was one of the questions I wanted to ask you. So in, in the ETF structure. Right. Are there other risks and potential benefits that advisers really ought to think about when they're looking at these products? Yeah, I think the most important one is, in a leveraged ETF, particularly the short ETFs, when they're rebalancing daily. You have a basic tendency of that instrument to grow larger against you when you're wrong. Right. So you don't really wanna buy and hold these instruments. They should really be thought of as hedging tools. At least the short ones. The long ones. They still have the rebalancing problem, but it's not quite as acute. So, think of them as short term hedging tools, not as buy and hold instruments. Okay, and use, you personally use leverage ETFs, and, tell us a little bit about, kinda, the due diligence that you do. And you talked about, I mean, they're not necessarily a buy and hold type of vehicle. So does it take a lot of hands-on time for you as a user of leveraged, leveraged ETFs. Yeah, so, so we run a fund, a, a mutual fund, MIGTX, the Morgan Creek Tactical Allocation fund and in that we can go both long and short. But there are limits on how much we can be short, in terms of actual dollars. So if we want to have a lower net exposure in the portfolio, cuz we're concerned about valuations or something. We may use some of the levered long ETFs and go short them. So it gives us more oomph on the, on the protection side, more hedging. Right. In July we'll probably start managing something called GTAA, Global Tactical Allocation. ETF, and it'll be a basket of ETFs and within that we may use a levered ETF to gain exposure. Either positively to a market that we're really bullish on, or, again, in a hedging way. We can't go short in that, we can just be long, but we might use, for a short period of time, one of the short ETFs Okay. So it does. It sounds to me anyway, Mark, that using leverage ETFs is, and it kinda speaks to your earlier comment as well Okay. About not really being, a buy and hold type, type of strategy. It sounds like it does take a fair amount of hands on Yeah. And, and you asked the question. I didn't answer about [LAUGH] due diligence. So, you know, one of the things about diligence is. You want to dive into what you actually own, and with ETFs it's not so much that there is some active manager out there. Right. That you have due diligence. In our other life we manage fund to funds. Registered investment company funds like our global equity long short fund. That you can buy as a REIT. There were actually diligencing managers. Right. You know, we want to go on site. We want to see where their educated. Who their mentors were. You know what their process is. What their philosophy is. Right. In ETF, you gotta know what the process of [UNKNOWN] are. It's set out as quantitive. So really the diligence there, what are the assets of the entity. Is it a good strong company that your working with, you know do you have a run on the bank risk. Really in any sorta leverage structure, that's the trouble. If you have a run on the bank it will amplify the move. And Warren Buffet has a great quote about this, he says any business model that is dependent on the kindness of strangers. The leverage provider is doomed to fail. Now I think that's a little extreme in this case. I think level ETFs can certainly play a role. But I think you have to know how much capital is in there. What type of holders are they. Are they long term investors or short term traders. And at least be cognizant of those risks. Okay. Right. Very good. Well, that's some good insight into this issue of leverage ETFs. Which, again, you know, hit the headlines after Larry Finks said they could blow up big. Yeah. So, I appreciate you coming by, Mark, and having this discussion with us. No, thanks for having me and look forward to doing it again. Okay. [MUSIC]

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