Financial Leverage, Part Two: Don't Say We Didn't Warn You

A larger ball is up in the air on a scale, while the smaller ball is down.

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In December, Kiplinger.com published my article about the risks and rewards of investing in highly leveraged cryptocurrency-related securities, What to Know About Leverage and Bitcoin’s Meteoric Rise. Recent events affirm the importance of the primary lesson in that article.

That lesson is: With any financial investment — not just crypto — financial leverage can magnify gains, but it can also magnify and accelerate losses.

A financial leverage hypothetical

A biologist, a chemist and an investment banker walk into a bar. The only other patron is a gent wearing a deerstalker hat, smoking a pipe, sipping a glass of Burgundy and reading the Baker Street Gazette. Let’s call him Sherlock.

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The biologist and the chemist explain to the investment banker that they have developed a pill, which, when taken once, will allow an adult to engage in unassisted human flight for the rest of their life. It can be produced for $1,000 a dose.

The biologist shows a video on his cellphone of humans after taking this pill. The chemist notes that he himself has taken the pill, stands up, hovers two feet off the floor, changes direction a few times and returns to his seat. He notes there have been no side effects.

The two scientists want to form a corporation called Autopilot. The investment banker estimates that an initial public offering (IPO) of Autopilot could raise $1 billion and still leave the chemist and biologist in control of the company.

At this point, Sherlock puts down his paper, walks over to the men and introduces himself. “Forgive me, gentlemen, but I could not avoid overhearing your conversation and seeing your demonstration. Very impressive. But if I may, I would like to suggest to you that you have underestimated the amount of profit you can make on your venture.”

“How so?” asks the investment banker.

“It is elementary — and understandable. You have focused on why many people would want to buy Autopilot technology and based your calculations on that basis. But you have omitted considering the people who will suffer if unassisted individual flight becomes commonplace. So I ask you: Who suffers if your product becomes the new normal way of transport?”

The investment banker says, “Automobile manufacturers and their employees. Railroads, railroad car manufacturers and other companies that deal with any other form of personal travel. Perhaps even airplane manufacturers.”

“Quite so,” Sherlock says. “I would be very happy to invest in your enterprise. I intend to call my broker tomorrow and order a short sale of the Dow Jones Transportation Average. I will deposit the proceeds of the short sale with you for my future purchase of shares of Autopilot.”

This is real, not a hypothetical

The news is this: A financial instrument now exists that purports to offer leveraged upside gains for the purchase of a promising technology and profits from the short sale of a potentially outmoded technology. This would be an exchange-traded fund (ETF) launched by Defiance ETFs: Battleshares TSLA vs F ETF, with the amusing ticker symbol ELON.

Simply put, this ETF purports to give owners double exposure to Tesla (TSLA) stock, using a variety of leveraged methods to do so, while also raising cash through the short sale of Ford (F) stock. That cash is plowed into Tesla securities purchases, thus adding an additional point of leverage.

People who believe that Tesla will rise at the direct expense of Ford are the target audience for this ETF, which launched in mid-February.

Other similar Defiance ETFs that go long with a prospective winner and short with a prospective loser are on the way. For example, you could buy an ETF that goes long on Google’s parent company Alphabet (GOOG) while shorting shares of New York Times Co. (NYT).

During its brief existence, investing in ELON hasn’t gone well. Even if you are only a casual consumer of financial news, you will realize that Tesla stock has had serial adverse hits in the short time ELON has been public. And because of the leveraged nature of its investment strategy, ELON has lost two-thirds of its value.

Your homework

When a corporation offers its shares to the public, it issues a prospectus outlining every aspect of the company’s business, including how it is financed, strategies, methods, current ownerships … and risks. Issuing a prospectus is required by law.

A prospectus is written, intentionally, in dull, technical language. Nobody. Ever. Reads. A. Prospectus.

You should. Why? Because the attorneys who write these things rack their collective brains to point out every conceivable thing that could damage the company’s stock price. A prospectus will carefully and truthfully inform you of every risk the company faces.

That is designed to insulate the company and its original owners from liability when something does in fact go wrong. This is a “we told you so” defense.

I refer you to the summary prospectus of ELON. In particular, feast your eyes on the litany of principal investment risks that start on page 4. It is quite a “parade of horribles.”

Outside of that, apparently, nothing could go wrong. Since we are focusing on leverage risk, the prospectus forthrightly notes on page 6 that:

“The Fund’s use of leverage amplifies both potential gains and potential losses, which can result in significant volatility for investors … (and exposes) the Fund to heightened risk if the Long Position performs poorly while the Short Position performs well.”

That potential risk summarizes the performance of ELON to date.

The bottom line: Invest in highly leveraged products with your eyes open

The world is full of investment bankers, entrepreneurs, MBA candidates and, alas, the occasional scoundrels who want to show you the next easy path to untold riches. Go through both the potential upsides and the potential downsides of any investment, as Sherlock would do.

“What could go wrong?” is always a question worth asking.

As you consider whether to invest in a vehicle that has more than the usually leveraged risk components, you should determine — beforehand — your tolerance for rapid losses as well as the possibility of when you would take your profits should you pull the right levers. Only you can make that call.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Stephen Harbeck served as President and Chief Executive Officer of the Securities Investors Protection Corp., a nonprofit created by Congress to protect customers of failed brokerage firms, from 2003 to 2018. He guided SIPC through the insolvency of Lehman Brothers, the largest bankruptcy in history, the collapse of Bernard Madoff’s brokerage firm, the largest Ponzi Scheme in history, and other major insolvencies. Harbeck retired as President and CEO of SIPC in 2019. Since then, he has acted as a consultant to the Shanghai Financial Court, and Shanghai Jiao Tong University, and is currently a consultant to the Japan Investor Protection Fund.