Mike Khouw on Leverage, Options-Based ETFs, and Investor Risk

Growth of Options-Based ETFs

• 📈 The options market has experienced substantial growth, outpacing equity volume growth over several decades.
• 💡 The proliferation of weekly and daily options makes them logistically challenging for most retail investors to manage independently.
• 🧩 ETF wrappers democratize access to strategies like selling covered calls, making them more accessible.

Risks of Leveraged and Inverse ETFs

• ⚠️ A significant concern is that investor education and understanding of these complex products are not keeping pace with their rapid development.
• 🎢 Leveraged products are appealing in rising markets but are a double-edged sword, struggling in volatile or declining environments and potentially underperforming underlying assets.
• 🧩 Tracking error can be introduced in choppy markets due to the frequent adjustments required by these strategies, especially those using options to achieve advertised leverage.

Demand and ETF Issuer Strategies

• 🚀 Over a thousand new ETFs have launched this year, with about a third using some form of leverage, indicating significant supply.
• 🎯 Retail investors, particularly younger ones, are seeking higher potential returns than traditional market averages, influenced by pandemic trading and possibly crypto.
• 💰 ETF issuers are in an arms race to offer the most leverage or highest distribution rates, as success with even one or two products can be crucial for their business survival.
• 🏦 Issuers of these complex products often do not compete with large, established firms like Vanguard or iShares, facing less competition.

Advisor and Investor Perspectives

• 🛠️ For longer-term allocators, most financial advisors avoid leveraged and inverse products, reserving them for more tactical trading strategies.
• ⚖️ While futures and options can offer advantages if implemented independently, understanding the underpinning securities is critical.
• ⚠️ Paying higher fees (around 1%) for options-based ETFs might be justifiable for investors who lack the time or expertise to manage the complex, frequent adjustments required.

Defined Outcome vs. Leveraged ETFs

• 🎯 Defined outcome ETFs are generally easier for investors and advisors to understand due to their predictable caps and buffers, leading to significant adoption.
• 📉 Leveraged and inverse products, conversely, carry the potential for significant losses and unpredictable outcomes, making them less appealing to traditional advisors.
• ⚠️ While ETFs have democratized access to complex strategies, many retail investors may ultimately get burned due to a lack of understanding of how these products work.