Are leveraged ETFs for me?

You know you have made it as an investment product when people starting demanding that you provide greater disclosure. As Jonathan Chevreau reported, a lobby group has demanded greater disclosure on the risks involved in purchasing leveraged exchange traded funds (ETFs), of which several ETFs now consist some of the most traded stocks daily on the NYSE and the TSX.

The calls for greater disclosure in leveraged ETFs appear to be a reaction to the fact that retail investors are now purchasing these products and investor rights groups are concerned that investors are purchasing something they understand.

LEVERAGED ETFs: THE QUICK AND DIRTY

The “what” is easier to explain than the “how”. A leveraged ETF is an ETF that aims to return some multiple of an index or benchmark’s performance either positively or negatively. For example, a bull EFT may aim to perform 2 times the return of a particular index whereas a bear ETF may aim to perform 2 times the loss of a particular index. Thus, if the market goes up 1%, a bull ETF with “double exposure” would theoretically return you 2% for that day.

Each ETF states an exposure which is the level of leverage required. Thus, a 2x short exposure means it aims to perform double the daily performance opposite of an index or benchmark.

The “how” is the complicated part. An ETF bull or bear ETF achieves its return through purchasing financial derivatives such as future contracts or equity swaps. The key, however, is that everyday the ETF needs to re-balance itself to its appropriate fixed exposure/leverage level. In other words, at the end of each day, the ETF has to buy or sell positions to re-establish its leverage position. Remember this part, this is key.

LEVERAGED ETFs: WHY WOULD YOU BUY IT?

Why you buy a leveraged ETF depends on your context. If you sit on the trading floor of a major financial institution, leveraged ETFs are a relatively easy method to be a momentum trader. Buying and selling derivative contracts (which is one way of creating an ETF yourself) may simply take too long or you do not have clearance to do it (there are rules on who can buy what; a retail trader does not have the same access or volume of product as an institutional trader). If you believe the market is going one way or another, a bear or bull ETF may be a simple way for even the lowest of institutional traders to play the trend (as the saying goes, “the trend is your friend”). This explains the enormous volume in leveraged ETFs.

If you are a retail investor, you most likely buying on speculation or as a hedge. I am going to quote Preet in his excellent post about leveraged ETF’s describingthe difference between the two concepts.

“Hedging is the complete opposite of Speculation. Another way to put it is that speculation is the taking on of risk in the hopes of a higher reward, and hedging is the elimination of risk and the elimination of higher potential rewards. The two are diametrically opposed.”

I have no issues with speculation as long as one can handle the downside risk of losing your own money (institutional investors speculate too- just mostly with other people’s money) and if one is absolutely positive that the market is going one way or another in the short term. If this applies then this may be a convenient product to achieve one’s goal of speculating on the market. As a hedging tool, it tends to be, as Preet noted, a good tool in small doses and for short peroids of time (as explained below). As long as one understands this, a leveraged ETF can be an effective tool.

LEVERAGED ETF’s WHAT IS THE DOWNSIDE RISK?

There are many disadvantages to leveraged ETF’s but I wanted to concentrate on one known as the Constant Leverage Trap: Over time, constant leveraging in volatile markets diminishes returns. I am going to let some professors explain this concept on their research on leveraged ETFs quoting their example of the constant leverage trap:

Assume you invest $100 in both a market index and a 2x leveraged ETF. The index falls 10 percent, and thus the leveraged ETF falls 20 percent. The next day the index increases by 20 percent and the leveraged ETF increases by 40 percent. Your portfolio value in the index falls to $90, and then increases to $108, for a gain of 8 percent. Note the average return is 5 percent each day, yet your portfolio only averages 4 percent each day. This is the compounding problem. In the leveraged ETF, your portfolio value falls to $80, but only increases back to $112, for a gain of 12 percent. Instead of averaging 10 percent each day, your portfolio only averages 6 percent each day. The leverage ratio for each day is two, but over the two days is only 1.5 (12 percent divided by 8 percent). Thus, the compounding problem is magnified by the use of constant leverage.

In plain English, this means the ETF can consistently maintain its stated exposure/leverage position BUT CANNOT DELIVER YOU THE SAME RETURNS AS ITS EXPOSURE OVER A PERIOD OF TIME.

In other words, don’t assume you are receiving the same level of return as its exposure.  In fact, over time, returns will be less than the exposure.

The implications of this are manifold:

1. Definitely not for someone with a buy and hold strategy;
2. A product that optimally performs when there are long to medium terms trends and not in a volatile market;
3. Its usefulness as a hedge declines over time;
4. A useful product for short-term hedging rather than profit-seeking.
   

…I would be remiss if I did not point out the following. Good investors are good historians. Recent history shows that sophisticated financial products aimed at the wrong end-user combined in faith in financial wizardry tends to end badly.

If you are a long time reader of this blog, you notice that I tend not to be an early adopter of financial trends. I like to see how the dust settles before writing about something new. Thus, while I do not dispute the utility of this product in the right hands, I fear for some retail investors that this is nothing more than a stroll down memory lane, substituting the names of some recent structured financial products like ABCP or PPN with leveraged ETFs.