Leveraged ETF debate continues

Despite relatively widespread media coverage and a formal warning from the Investment Industry Regulatory Organization of Canada (IIROC), one investment group continues to call for more rules to govern the sale of leveraged exchange traded funds (ETFs).

The Canadian Foundation for the Advancement of Investor Rights continues to call for greater regulation of leveraged ETFs, suggesting they are inappropriate for retail investors and are inappropriately used by many investors.

Unlike a traditional ETF which attempts to replicate the performance of an underlying security index, leveraged ETFs use futures and options contracts to give leveraged performance with or against a specific index without the unitholder having to actually take on leverage beyond their initial principal investment.

The products are one of the big success stories for the investment industry, and the country’s sole provider of Canadian domiciled leveraged ETFs, Horizons BetaPro, manages around $2.4 billion in its leveraged ETF lineup. They are often amongst the most actively traded securities in Canada.

In order to make them a feasible business model for the provider, leveraged ETFs need to be rebalanced daily so that new investors to the funds can benefit from accurate index tracking. If an investor holds a leveraged ETF beyond a day, it can build up tracking error that may grow the longer it’s held without rebalancing.

If an investor put $100 in a leveraged ETF that provides two times performance on an index, and the index goes up 10% the first day it was purchased, the ETF would go up 20%. The ETF is rebalanced to ensure that it maintains its perfect 2:1 leverage for the next day. The investor’s holding will be worth $120.00 per share if they don’t sell out, but they now have a leverage exposure that is different than then the rebalanced ETF.

If the index goes down 10%, the ETF goes down 20% again. That’s 20% of the new value of $120 per share, which is $24 per share, leaving the investor with $96 per share to start the next day. The investor’s holding no longer reflects the value of the index after those two days.

“These derivatives-based ETFs are like wolves in sheep’s clothing. On the surface they look like plain vanilla ETFs, but they have very different holdings, returns and risks,” says FAIR Canada executive director Ermanno Pascutto. “Extensive advertising lures investors based on incorrect inferences as to the correlation of the products to their underlying index or commodity. People who ‘invest’ in these ETFs for a length of time are likely to suffer significant losses even if they guess correctly on the direction.”

Pascutto adds, over the last 12 months, 5 of the 9 pairs of leveraged ETFs listed on the TSX lost money (i.e. both bull and bear were losers).

Both IIROC and the media, in addition to the prospectuses of the leverage ETF products have made it clear, you must buy and sell the products daily in order to perfectly correlated performance. Pascutto maintains that this warning is not enough.

FAIR wants the provincial securities commissions to implement risk disclosure and acknowledgment requirements for any retail investor who wishes to trade these products similar to requirements for trading derivatives such as options and futures contracts.

Among other requests, FAIR wants advertising for leveraged ETFs to require warnings on both advertising materials and websites. It wants regulators to review existing print, TV and web-based advertising and enforce restrictions on misleading advertising through disciplinary proceedings.

Finally, FAIR wants the products to be reclassified as Listed Derivative Products or LDPs.

“This is not a small problem. Canadian investors now hold $2.5 billion of Horizons BetaPro products, plus an unknown amount of U.S. leveraged, inverse and commodity ETFs. Urgent action to protect retail investors is needed,” FAIR’s associate director Steve Garmaise says.

Garmaise’s quote is slightly misleading. According to Howard Atkinson, the president of BetaPro Management, roughly 60% of the $2.4 billion in Horizon’s are held by institutional investors, rather than 100% being held by retail investors.

Many institutional investors use the products as hedges for their sizable portfolios. A hedge position on a certain market or asset class can be purchased for half the price without taking on the additional leverage risk — such as margin calls — that can accompany shorting strategies.

Of the remaining 40% of HBP ETF investors, more than half are using a licensed advisor. A new research study by Levi Folk Research, which BetaPro management is distributing, makes it fairly clear that using and understanding the risk of these products is probably within the abilities of majority of IIROC licensed advisors who are allowed to sell them.

“This is the simple math that dictates the performance of leveraged ETFs. Each day investors get twice the return of the underlying index or benchmark. Therefore, on day two, if the index gains an additional 3%, the two-times leveraged ETF rises a full 6%, but a passive margin account rises less, by +5.83%,” writes Levi Folk, the study’s author. “Leveraged ETFs therefore undergo daily rebalancing — adding borrowed funds on up days and removing borrowed funds on down days — to maintain constant leverage.”

Folk shows in the study that leveraged ETFs can be used somewhat reliably for a period longer than one day, if the market path for the index the fund tracks trends in one direction. The products will need to be rebalanced daily if daily returns are volatile, swinging in different directions.

“Highly volatile markets are the least intuitive for estimating leveraged ETF returns over extended holding periods because volatility magnifies the compounding effects of leveraged ETFs,” Folk writes. “For example, an index that rises 25% one day and falls 25% the following day will continue to lose money because the 25% loss is compounded on a higher amount of capital, while the 25% gain is compounded on a smaller amount of capital. Investors need to monitor their investments in times of market volatility to achieve desired returns and to reduce portfolio volatility.”

While generally seen as a passive product, leveraged ETFs need to be actively monitored by the investor or their advisor. If the market direction is relatively stable, the ETF can return somewhat correlated returns — although not perfect — without rebalancing. Action will likely need to be taken in volatile market conditions.

“In a highly volatile market, investors may wish to offset the effects of two-times daily leverage on their investment returns. This can be achieved by selling shares (reducing exposure) on gains and buying shares (increasing exposure) on falls,” Folk writes. “By injecting additional capital on declining days and withdrawing capital on advancing days, an investor can reduce risk and reverse the effects of rebalancing to two-times leverage. Recall that two-times leveraged Bull ETFs reduce notional borrowed funds when the underlying index or benchmark falls and increases notional borrowed funds when the market advances.”

He adds, “Also remember, the reason for the daily rebalancing is to limit risk to the capital invested. This has the added benefit of no recourse or forced liquidations, unlike a margin call.”

(07/15/09)