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A Hard Lesson in Leveraged ETFs

Investing in leveraged ETFs is a great way to capture outsize long-term gains … if you can stomach the increased short-term volatility that comes with them.

Investments Exploding Over Compound Dividend Reinvestment, Leveraged ETFs And  Share Equity Growth High Quality Rising Arrow

The stock market is constantly teaching us, no matter how long we’ve been investing. I learned one of its many hard lessons just last month when I sold out of a long-beaten-down leveraged ETF … right before it tripled in a matter of two weeks.

The leveraged ETF I’m talking about is the AdvisorShares MSOS 2x Daily ETF (MSOX), a marijuana ETF that moves twice as much – in both directions – as the AdvisorShares Pure US Cannabis ETF (MSOS), a fund whose holdings include some of the top publicly traded U.S. cannabis companies. I added MSOX to my Cabot Stock of the Week investment advisory (which recommends a new stock every week that was previously given a stamp of approval by a Cabot analyst) in early July, thinking it was a great time to take a flyer on the cannabis sector after marijuana stocks had been beaten into submission for two and a half years. Turns out, I was about two months “early.”


The MSOX promptly nose-dived another 25% over the ensuing four weeks, and I quickly bailed, advising my Stock of the Week subscribers to cut their losses. Here’s what I wrote to them, on July 31:

“I’ve lost patience with the cannabis sector as a whole. Wake me up when cannabis stocks rally for longer than a couple weeks without immediately getting sold off for the first time in two and a half years. So, MSOX is out.”

Well, I’m awake.

On August 29, the Food and Drug Administration (FDA) and its parent Department of Health and Human Services (HHS) recommended reclassifying marijuana from a Schedule I drug – i.e. lumped in with heroin, LSD, ecstasy, peyote and other notoriously dangerous narcotics as being “drugs with no currently accepted medical use and a high potential for abuse” – to a Schedule III drug, meaning it would have an “accepted medical use in treatment in the U.S.”

The FDA recommendation – which will require Drug Enforcement Administration (DEA) approval to become law – is a big deal for the cannabis industry, and cannabis stocks have gone through the roof in the two weeks since. The New Ventures Global Cannabis Stock Index, a good benchmark for the cannabis sector, is up 44% since the August 29 ruling. But that’s a pittance compared to the performance of MSOX, which – again, it’s a leveraged ETF – is up 180% during that time, even after a sharp (10%) pullback on Tuesday. If I had simply hung on to the MSOX fund in my Stock of the Week portfolio, my subscribers and I would be sitting on an 83% gain in just over two months. Sigh.

The Leveraged ETF Conundrum

Of course, this isn’t lost money. It’s a squandered opportunity. There’s a difference.

The reason I bailed so quickly on MSOX was because it had already fallen so precipitously, losing a quarter of its value in less than a month. As a rule, I try to keep losses in my Stock of the Week portfolio to a minimum, and 25% is about the limit in terms of the kinds of losses I’m willing to stomach. But in maintaining such strict loss limits (though 25% isn’t a hard-and-fast rule), I run the risk of selling out of a great intermediate-to-long-term investment before a major catalyst (like cannabis rescheduling) arrives.

Which brings me back to leveraged ETFs. They are, by definition, higher risk than non-leveraged funds. When the sector they cover retreats, they retreat even further – twice as much, in MSOX’s case. To hang in there with them, you have to be willing to weather potentially major dips. And the only reason to stick with them is if you truly believe in the sector/index for which they’re acting as an exaggerated proxy. In essence, long-term investing in leveraged ETFs requires something of a leap of faith.

So was I “wrong” in selling out of MSOX too soon? In a vacuum, no. I have a fairly strict loss limit, and I stuck to it. It’s important to have an investing system, and it’s even more important to stick to that system. But it also makes sense to have some flexibility and nuance within that system.

My investing system calls for limiting losses to no more than about 15-20% … generally. The reason it’s more of a loose “rule” and not an absolute one is to account for higher-risk plays like a leveraged ETF, which are far more volatile than the average bear. Such investments are exceptions to my loss limit rule. And that’s why I allowed it to fall 25% before giving it the heave-ho. Should I have given it a longer leash? Perhaps. But that’s easy to say in retrospect.

Whatever your system or risk tolerance may be, it’s important to know your threshold going in when investing in a higher-risk play – be it a leveraged fund, a micro-cap stock, an IPO, etc. In this case, I deemed 25% as about the limit in terms of the loss I was willing to absorb, and I stuck to it.

I can live with that decision … even if it meant missing out on some big profits.


Chris Preston is Cabot Wealth Network’s Vice President of Content and Chief Analyst of Cabot Stock of the Week and Cabot Value Investor .