Aaron's Blog

We all know buying stocks with leveraged money is a dangerous game. Why isn’t the same said for investing in leveraged ETFs?

Leveraged ETFs (exchange-traded funds) are some of the most sophisticated financial instruments available to the retail investor. In many cases, investors really don’t have a clue how they work and the best way to play these crazy things.

Leveraged ETFs have been around for 20 years but they only hit the mainstream in 2006 after the SEC spent several years reviewing their merit and if they were suitable for the investing public.

By 2008 leveraged ETFs were taking off, in parallel with the market crash. The reason for this was simple. Investors couldn’t make money off the stocks they owned because they were falling from the sky. The lure of making 2 times (and even 3 times) daily index returns was too tempting. It was the one thing that made sense to investors. They could make money in a bull or bear market and at the same time, make two or three times the return of the index or commodity on a daily basis. It sounded wonderful, especially since everyone had just lost a fortune in the crash and was hoping to make their money back quickly with these heavenly products...

Well, little did most investors know, these leveraged ETFs were not as wonderful as they first appeared.

Leveraged ETFs are designed to give investors a greater return (typically 2 or 3 times) than regular long or short positions. So, in layman terms, if you were to buy a leveraged ETF (long) which tracked the S&P 500 you would get 2 times the daily return of what the S&P 500 did - at least that’s what they are meant to do. If the S&P increased 2% on Wednesday, theoretically, if you were long an S&P leveraged ETF, you would make 4% on your money. Sounds very simple, but it is far from it. And this is what investors need to realize before they get involved in such financial products.

The risk behind these products lies in the name: LEVERAGED ETFs. Anytime leverage is involved in investing, risk is multiplied. Never forget that. When you borrow money to invest, you are subject to double risk. The risk of losing on the investment, and the risk of servicing the interest and debt taken out to pay for the investment. Same applies for leveraged ETFs. Let me explain.

Maintaining a constant leverage ratio, typically two-times the amount, is complex. Fluctuations in the price of the underlying index change the value of the fund’s assets, and this requires the fund to change the total amount of index exposure.

So, let’s say, for simplistic purposes, a leveraged ETF has $100 million in assets (cash invested from investors). It must then have $200 million of index exposure in order to provide investors with double the return on a daily basis. How does it get that $200 million? The fund borrows it. And when the index rises or falls, it is a constant rebalancing act. If the index rises 1% in a day, the fund now has $102 million (double the return  - 2% of $100 million) in assets (cash invested). But, in order to make sure it has double the exposure for the next day, the fund must now borrow more money because its assets have gone up. So, instead of borrowing $200 million, it now has to leverage $204 million. Sounds backwards doesn’t it? The more the fund gains, the more it borrows. Isn’t the purpose of investing to create wealth and borrow less? I know that is a very elementary example, but it proves the point that these things are toxic in nature. Let me explain what happens when things go the other way and what that does to participating investors.

Now that the fund had a winning day and has gone from $100 million in assets to $102 million and from $200 million leveraged to $204 million leveraged, what happens if it loses the next day and volatility kicks in?

The next day roles around and the index being tracked loses 1%, meaning the leveraged ETF  should lose 2%. Where does that leave the ETF in terms of net asset value? Its assets (cash invested) drops to $99.96 million. But wait, if it gained 2% the previous day and lost 2% today, shouldn’t it be right back where it started at $100 million. Unfortunately not; thus the danger in these instruments. But that’s not even close to where the danger ends if you bet (bet being the operative word) wrong. What happens to all the leveraged money? That $204 million has now lost 2% as well which leaves its worth at $199.09 million. So now the fund has to pay off that outstanding amount (over $4 million) it just lost in leveraged money which creates even more pressure on the unit price. So in reality, instead of the ETF losing 2% that day, it likely will lose closer to 3% (that extra 1% is just hidden, temporarily).

But wait, there is more expenses taking away from your profit..or adding to your losses.

Like all funds, these leveraged ETFs have what is known as management expense ratios (MERs). This is what the fund unit holders pay to the manager who controls the fund and balances it out daily. Typical MERs are around 1% annually (this can add up). But wait, there’s still more expenses investors must pay for...

Everyday the fund manager has to rebalance its holdings depending on what the market did. The fund manager is constantly buying and selling derivatives to maintain a target index exposure. I explained this above. But what I didn’t mention is that buying and selling derivatives to maintain index exposure has transaction fees associated with it. Who pays for these fees? The unit holders do (the investors in the ETF). Yet another expense hidden in the fine print. This takes away even more from investors profits...or adds to their losses.

I’ve tried to keep it as simple as possible when explaining how these crazy things work. I hope I’ve done a good job at scaring you away from holding these financial products for the long-term. Too many unsuspecting investors (and they are part to blame) have seen their capital crushed by holding onto leveraged ETFs.

There are only two ways I would play leveraged ETFs. The first would be to day trade them. And I mean DAY trade! Do not hold onto them overnight or your risk just multiplied. And make sure, unless your a pro, that you’re using only fun money (money you can afford to walk away from) because leveraged ETFs are incredibly risky.

The second way I’d play them is to short them. Leveraged ETFs are the best long term capital eroding investment out there. Check this example out. Let’s look at the chart for the leverage ETF by Horizons BetaPro which is long natural gas - HNU ( I use this example because it is a very popular one here at Pinnacle).

Take a look at the 1 year chart for the Price of Natural Gas:

Abnormality in the market today - gold and the dollar are moving in the same direction. They’re going up!

One is undervalued still, one isn’t. But I don’t need to tell you which one as it’s quite obvious. So let’s continue.

When you look at the headlines and apply common sense, it’s not that strange to figure out why both gold and the dollar are up on this down day.Greece is unravelling and it is causing the speculators of the world to apply the guilty by association rule to Ireland, Portugal and Spain.

Greece’s credit rating was cut three steps to junk by Standard and Poor’s. This is the first time a European nation has lost its investment grade since 1999 when the currency was introduced.

The Euro is in deep deep trouble. I don’t know where the buck will stop, but I don’t think parity between the Euro and US dollar is

As an investor who holds positions in junior gold stocks, I can’t help but get excited after reviewing the latest financial results from some of the majors. The major gold producers are starting to show the profits that come with historically high gold prices. The Q4 results from some of the majors signaled what will likely be a long-term merger and acquisition period amongst gold miners.

Kinross Gold (KGC:NYSE), Barrick Gold (ABX:NYSE) and Newmont (NMC:TSX) all showed great profits in the final quarter of the year, representing the high gold prices in the last half of 2009.

Kinross reported a profit for the fourth quarter compared to a loss in the same period a year-ago. Earnings per share for the quarter more than doubled and topped analysts' consensus estimate. Revenue for the quarter surged 44%.

Barrick Gold’s profit margins rose to $645 an ounce from $338 a year earlier. Barrick earned $215 million, or 21 cents a share in the fourth quarter, compared with a loss of $468 million or 53 cents a share a year earlier. Barrick booked a record adjusted profit of $604 million, or 61 cents a share, up from $277 million, or 32 cents a share a year earlier.

Newmont Q4 profits skyrocketed as well. The company earned $558 million, or $1.13 per share, compared with $4 million, or a penny a share, during the same period last year.

Long story short, the majors’ pockets are getting fatter and will continue to swell for a very long time.   Just imagine what kind of profits the ‘big boys’ will turn out when they have the next 2 to 3 years to sell their bullion for more than $1100 per ounce. Remember, last year gold prices averaged around $950 an ounce; those days are behind us and the average gold price is going to be much higher. For every $100 increase in bullion prices, companies such as Barrick, which produces nearly 8 million ounces per year, will potentially increase their profit margin by nearly $800 million annually. They can scoop up a lot of great junior gold miners for that extra chunk of change- and I fully expect them to do just that.

With the global output for gold declining by nearly 1 million ounces per year since the early 2000’s, producers have been nervously searching for their next acquisition. This is one of the most competitive industries in the commodity sector. The majors are in a race to scoop up as many quality assets as they can find before their competition beats them to the punch.

Just yesterday Kinross reached a deal to buy out Underworld Resources (UW:TSXV). The deal is worth nearly $140 million - a drop in the bucket for a company like Kinross.

With a lack of quality assets available in the gold sector, majors will be forced to either pay hefty premiums for the giant deposits (2 million ounce plus) or take on more of a role in exploration and FIND the next giant deposit. I don’t see them doing the latter unless through a joint venture which will almost inevitably lead to a buyout for the other company involved (provided the asset is economic). Majors know production, historically, they have failed miserably in prospecting and exploring(I can’t count how many great deposits I know of which were abandoned by majors in the past and now owned by junior explorers who are proving them up to be world class deposits). This opens the door for the explorers to be bought out.

There is still a major valuation disconnect between explorers and producers. Explorers as a whole are still very cheap. Majors, however, are not. Their true value, I believe, has been priced in.  Of course that will change as the price of gold rises, but juniors are cheap even with today’s gold prices. Heck, a lot of them would still be cheap if gold was $850 an ounce.
So how do you find a potential buyout candidate in the gold exploration sector?

Here’s some loose guidelines of what I look for:

If you want to know why Government should never get involved in the private sector, look no further than what has gone on with the Toyota recall fiasco.

Toyota, which employs over 35,000 (non- union) workers in the United States with factories in eight states, is the target of a government-led attack thanks to the recent recalls. It is the largest recall of vehicles in automotive history.

The recalls are due to what is known as SUA (sudden unintended acceleration) and was first blamed (by the media - influenced by the White House) on sticky gas pedals, then a floor mat problem and now faulty electronics. Not surprisingly, no exact issue has be proven to be the cause of the SUA.  

Thanks to the US government’s attack on Toyota, 15,000 Lexus HS250h and 133,000 Priusmodels will be recalled due to gas pedal issues and another 500,000 Prius models due to anti-brake software modification. There will certainly be more recalls to come, just give it time. The US government wants to be sure they wipe out Toyota’s sales completely in the US before they stop the recalls. Oh wait, I meant to say, they want to make sure they have thoroughly checked every inch of all Toyota cars to make sure the public is safe...Ya right.

All Toyota Recalled Vehicles

•    2005-2010 Avalon
•    2007-2010 Camry
•    2009-2010 Corolla
•    2008-2010 Highlander
•    2009-2010 Matrix
•    2004-2009 Prius
•    2010 Prius
•    2009-2010 RAV4
•    2008-2010 Sequoia
•    2005-2010 Tacoma
•    2007-2010 Tundra
•    2009-2010 VENZA

Toyota has now shut down its U.S. plants and stopped selling eight of its popular models, including the highly regarded, and one of the best ‘bang for your buck cars’ on the road, Camry. The US’ Toyota dealers estimate they’ll lose $2.5 billion each month that sales of these eight models are suspended. Kudos to the US Government, the next step for Toyota will be to indefinitely shut down

A story that is not making its way onto Wall Street, although it should be, is that US Silver Eagles sales set a record in January. I mentioned a few months back the dramatic effect it would have if Americans join the world investment community and turn away from faith-backed fiat currencies to embrace gold and silver bullion.... Well, it’s starting.

In my blog last November I mentioned the effect this kind of a change in sentiment would have on gold prices - silver is no different.

Excerpt from my blog written on November 27, 2009

“Remember the images of the Chinese citizens lining up by the thousands to purchase grams of gold? Bring that same mentality to America, where purchasing power is so much more per individual. Instead of gold being purchased by the gram, Americans will be purchasing it by the ounce, or more.

This very possible scenario could send gold prices

What an amazing game last night between the Saints and Vikings. I was thrilled with the result as my favorite team, the New Orleans Saints, squeaked out a victory over the ageless wonder Brett Favre and the Vikes in overtime. The game had me on the edge of my seat all night as it was a back and forth nail biter between two very equally matched teams. Fortunately for Saints fans, and my wallet, a 40 yard field goal in overtime won the game. Only problem, the way overtime works in the NFL just isn’t sitting right with me.

The NFL is the only sport of the four majors here in North America that comes down to a coin flip to see who gets possession first. The problem I have with that is that overtime in the NFL works in a sudden death format, meaning the first to score wins. So the team who wins the coin toss and gets first possession, clearly has a huge advantage over their opponent. Thankfully, my Saints won the coin flip last night and proceeded to score on the only possession in overtime, but I’m sure the Vikes’ fans are demanding a rule change which eliminates the coin toss, or eliminates the sudden death component of OT ; and quite honestly, I can’t blame them. This is the one issue I have with the otherwise perfect game the NFL has created. No other major professional sport gives an advantage in overtime to a team who guesses which side a coin is going to land on. How is that right?

Imagine battling it out for 60 minutes, desperately trying to earn a spot in the Super Bowl, and winding up with a tie score against your opponent. If that isn’t tough enough, imagine the outcome of that game coming down to which team guesses right on a coin flip.

I hope to see this rule changed in the NFL soon. Athletics and sport isn’t a guessing game, this isn’t roulette.

The Super Bowl game will be a tough one for the Saints as they battle Indy. However, the Colts defense doesn’t hold a candle to

by Aaron Hoddinott

As we move forward in 2010 our team will continue to have a constant level of exposure to precious metals in our portfolio - even more so than in 2009 if you can believe that.  The Fed has changed the way we must invest and if you don't adjust accordingly, you risk the potential of severe capital depreciation.

Given the blissful ride gold has taken us on, it’s easy to overlook other great hard asset investments i.e. silver, copper, oil, even real estate.

While I think gold is essential in my portfolio (both physical and gold shares), I think the investing world has fallen recklessly in love with the precious metal. This is investing, and to be successful, you have to diversify, especially in the volatile world of commodities and hard assets. While gold can be a great inflation play, it isn’t the only one out there and this blog is a friendly reminder of that.

I was at a dinner last night with a few investors and was amazed with the subject of our conversation. The group I was with are tech savvy investors and focused on many complex deals more confusing than a Rubik’s cube. These guys could tell you every little detail about the schematics of search engines with technical talk so unheard of I question if it is even English. Surprisingly, we spent the whole night discussing what gold stocks to buy. This was very odd to me given the people I was with. They are a very sophisticated group, but no very little about commodity investing. Only six months ago this group of friends couldn’t be bothered to even talk about gold or prospective deals in the sector. But now, given the attention the yellow metal has received in the media and politically, I must admit, they were sounding more like sheep (followers) than their usual innovative selves. Clearly my friends (and I have to stress that these guys are not commodity investors, never mind gold) have been influenced by all the hype around gold - A very dangerous thing and by the sound of our conversation, they hadn’t even considered the possibility of investing in another commodity.

For me, this was a wake-up call. A reminder never to fall in love with one asset just because everywhere you go, people are singing its praises. Step away from the crowd and really look at the situation without any influences. Sure, gold may double from here but time is money and I always look at an investment opportunity from the standpoint of ‘how long will it take for me to potentially double my money (time acceptance always depends on risk as well).

For me to double my money through buying an ounce of gold I would need it to hit $2,268 per ounce (never been that high). I’m not saying gold will not go to $2,268 an ounce, but I think it is at least 3-5 years away from that number. Silver, (currently trading at $17.56 an ounce) I believe

I spent this past week in San Francisco and while there, attended the Hard Assets Conference (which I highly recommend investors attend) to catch up with some colleagues and kick the tires of two companies I am very interested in.

While at the conference I attended seminars of Frank Holmes and Rob McEwen, two very sharp and proven investors. McEwen, in particular, was of great interest to me as this is the man who was responsible for the success of Goldcorp.  Frank Holmes, a very entertaining speaker, breaks down the commodity market better than anyone- discussing macro issues and how they will affect your portfolio.  If you ever get a chance to hear either of these two gentlemen speak, don’t miss it!

When in San Francisco, we took an afternoon to visit the UC Berkley campus and I was surprised by what I saw there. There was the annual End The Fed protest occurring on the overpass just off campus. This is a well known protest which occurs every November 22nd, but this year (with all that has been happening in the gold market) there was more to it than usual. I saw the typical End The Fed signs and a picture of Bernanke’s face on the banners. But the biggest banner, being held by 4 people who looked like they had just left Woodstock, read “Gold = Money.” This banner was so big I could literally read it from a kilometer away. 

When I saw the banner I remember thinking, this gold frenzy is just beginning and the more demonstrations there are like the one I witnessed, the more the American consumer will be influenced to purchase the precious metal.

America is the world’s largest consumer. Can you imagine what will happen to the price of gold if American consumers take on the mentality of these protesters?

Imagine what will happen to gold’s price when

Over the last couple months, through its traditional practices (i.e. direct leasing, gold swaps, forward hedging), the US Central Bank has struggled to keep the price of gold down. Due to recent difficulties, Washington led a campaign to persuade the IMF to sell 403 tons of gold into the market.

The purpose behind the 403 tons sale was simple:

Increase supply, thus decrease the value of gold.

You see, the United States was trying to protect the value of the dollar by forcing the IMF to sell a substantial amount of gold into the market. This was done with the intent of driving the price of gold down. Unfortunately for both Washington and the Central Bank, the help was granted, but it backfired.

India blind-sided the US by purchasing half of the 403 tonnes for sale, instantly driving gold up $30 an ounce – a very dangerous situation for the US Central Bank and more specifically for the US dollar.

Paul Craig Roberts who was Assistant Secretary of the Treasury in the Reagan administration said recently: "How long can the US government protect the dollar's value by leasing its gold to bullion dealers who sell it, thereby holding down the gold price? Given the incompetence in Washington and on Wall Street, our best hope is that the rest of the world is even less competent and even in deeper trouble. In this event, the US dollar might survive as the least valueless of the world's fiat currencies."

Since India made this large purchase, we have seen a continual rally in gold and the US dollar take a swift beating. Today was deflating for the US dollar as it slipped 1% against a basket of other fiat currencies. And no surprise, gold hit an all-time high with no signs of slowing down.

The ‘gold bug’ in me is thrilled to see the precious metal rally to record highs, but I am proceeding with caution at the moment. I’m convinced that the US Central Bank or Washington will

Watching the Yanks win last night was calming. As strange as that may sound (considering I’m a Mariners fan), it was a relief to see a historic American franchise back on top. With all that has been lost in America’s financial market, job market & housing market, it was reassuring to see the country’s most recognized sports franchise back to its winning ways after nearly a decade long drought. Call me crazy, but I think the victory has put a healthy jump back in America’s step (excluding Philly residents).

The Yanks' win reminded me of prior victories I’ve seen from great American franchises; franchises like the Cowboys, Rangers, Celtics, General Electric, Google & Microsoft. 

Sports are more than just a game. They can change a person’s mood in a matter of hours, or minutes, or even seconds. In tough economic times, when morale is low, anything positive that

It has been a crazy few weeks, so I apologize for my absence from my blog. I’m writing late tonight after an enjoyable dinner meeting discussing opportunities within the gold sector...Stay tuned.

As a matter of fact, my inspiration to write this blog arose during dinner tonight, but not from the engaging conversation, rather the beverage I was enjoying. I enjoyed a pint of Guinness with dinner and as anyone who has ever drank a Guinness knows, it is served with a nice layer of creamy froth on top!

I don’t know if you’ve been paying close attention to the markets of late, but I don’t think I’ve ever seen such a fickle, frothy market. It seems we have become a market that merely reacts on headlines and the rumor mill. What’s news in the morning is a distant memory by noon, making this market a very tough one to predict, unless of course you are predicting that it will be volatile. If that is the case, buy the VIX. I’ve got a low ball bid in for the morning.

Obviously, the employment numbers to be released this Friday is what everyone is waiting for. It will likely determine how the rest of the year will play out for the market. If less than 180,000 jobs were lost in October, then we will likely see new highs for the year. If over 210,000 jobs were lost, a 10-15% retracement for all major American markets is likely in my opinion.

If you missed the market action today, let me recap, as it was very telling in where we stand. Ford blew the socks off all estimates with their impressive Q3 report (don’t expect the same from other American autos) and The ISM Report was very encouraging as it rose almost 7 points to 53.1, the first time above 50 since July 2008 and its the highest since April 2006.

Sure enough, these great reports sent the market up in a hurry, with the Dow increasing 150 points. However, the run was short lived and by late morning the Dow was back in negative territory. Two months ago news like that would have sent the market on a two or three day rally, but not anymore.

Clearly from a technical and, dare I say it, fundamental standpoint, the market is frothy and overbought. The only thing that will save us over the short term is a “great” jobs report on Friday; great being relative to the disastrous job market in America.

The bulls have been on a tear for most of 2009, but it is clear momentum is grinding to a halt and the market wants to go lower. Don’t fear this. No market goes straight up and corrections are healthy as they allow for new levels of support to form.

Cheers,

Aaron

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Happy Friday everyone. To cap off the week, I've got a MUST READ for any investor. It comes from a very smart cat, Ron Coby - a 22 year industry veteran with a diverse background in securities. Starting on Wall Street in 1987, he has worked as a stockbroker, syndicate manager, investment banker, financial analyst, market strategist, venture capitalist and currently as a Registered investment advisor and hedge fund manager.

His article "Rising Oil Prices May Be the Forerunner to War" released today, is a great follow up to my

The community at Pinnacle Digest continues to grow and gain local and international recognition for being one of the more advantageous investor communities online. Thanks to all of you who make this site what it is. Your credible commentary is what makes it so valuable.

Enjoy the latest article in the press about our awesome investor community.

“Investment tips spread by word of mouse”
by Jeff Buckstein - Canwest News Service

Talk to you soon,

Aaron

Last week I commented on Gold’s strengthening market (September 30th, Gold, Greenspan & Shoes). This morning Gold hit a new all-time high of $1,045 oz after the US dollar continued its downward trend and Australia, to the admiration of many G20 nations, announced it will be increasing its interest rates. This boosted demand for higher-yielding assets, such as commodities and equities, hence the triple digit gains in major indices across the globe.

The US dollar’s role is in question as rumors are swirling about “secret meetings” between some of the BRIC countries, Japan, France and Middle East oil producers. These secret meetings, according to The Independent, a British newspaper, could be devastating to the US dollar.

“In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.

Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars.”

http://www.independent.co.uk/news/business/news/the-demise-of-the-dollar-1798175.html

These meetings have been denied by head officials of each country suspected of being involved (no surprise). However, if it is true, it would explain Gold’s recent rise.

Today’s record day for Gold, and even yesterday’s rebound, were not the doing of investors or funds acquiring Gold. There is a reason Gold has struggled for the last 20 months to stay above $1,000 oz. Think about how long it has taken Gold to get to this price point. Gold has had every reason to climb to record highs long before today, but in the past, has failed every time. Now, all of sudden, it breaks through to a new record high in convincing fashion?

There is only one explanation, and it’s more complex than just a weak US dollar or inflation fears.

What’s happening right now is a run on the US dollar by rising world powers like China and Russia. The world currency is believed to be the US dollar, but the truth is, and I’ve always been a believer in this - oil is the world currency. If you control oil, you control the world economy. Why do you think wars have been fought over it?

If China and the other countries in question (China is the one who matters in all of this) can trade crude in a basket of currencies (including gold) it puts everyone on a more even playing field and the US dollar’s future in jeopardy. China wants this potential outcome as they look to reduce their reserve weight on US dollars and increase their status to the world power.

I’ll bet China is spending its US dollars this week on a few things: gold, the euro and the yen, all of which could be included in the basket of currencies used for trading oil if this plan succeeds.

An economic war between the US and China has begun. China needs the cooperation of other powerful nations to overthrow the US and finally, they are starting to get it. I hope Obama isn’t too focused on his own homeland problems that he misses this storm headed straight for the US economy.

If gold has another big day tomorrow, I don’t see it dropping below $950 for a very long time.

Enjoy the evening,

Aaron
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