Shorting leveraged ETFs

Advisors will probably want to put this idea under the “don’t try this at home” category. But there’s a movement afoot to use shorting strategies on leveraged exchange traded funds (ETFs) to take advantage of the tracking drift in these products during volatile market cycles, if they’re held for a longer-than-average period of time.

Leveraged ETFs have been one of the big success stories of the last couple of years. They use futures and options contracts to give leveraged performance on or against a specific index, without the unitholder having to actually take on leverage.

They are often amongst the most-traded securities in Canada.

The products have come under scrutiny by investment advocacy groups such as The Foundation for Advancement of Investor Rights (FAIR), which a couple weeks ago demanded Horizons BetaPro, Canada’s leading provider of leveraged ETFs, amend it’s prospectus to note these are not suitable buy-and-hold products for retail investors. Because these ETFs rebalance every day, a volatile market cycle can leave investors with strong deviation in returns from the underlying index the ETF tracks.

“For the 12 months ending March 31, 2009, the S&P/TSX index of gold-mining stocks was up 1%. The Horizons BetaPro Bear+ ETF lost 87%. The Bull+ fund lost 46%,” says FAIR Canada executive director Ermanno Pascutto, in a report. “These were not anomalies. Four of the nine pairs of Horizons BetaPro’s leveraged ETFs, with at least a yearlong track record, lost money in both their bull and bear versions for the 12 months ended March. At least one member of virtually all of the other pairs suffered from significant tracking errors.”

This anomaly has prompted a heated discussion among many online finance bloggers, who question whether shorting a leveraged ETF would be of value. Preet Banerjee, senior vice-president of Pro-Financial Asset Management and writer of popular finance blog www.wheredoesallmymoneygo.com, is currently testing out the strategy.

The ETFs track the index on a daily basis very accurately. Banerjee points out if a 200% leveraged bull ETF is trading at $100 per share and the underlying index rises 10%, the ETF would go up 20%. The ETF now trades at $120.00 per share. However, if the index goes down 10%, the ETF goes down 20% again as well. That’s 20% of the new value of $120 per share, which is $24 per share, leaving the investor with $96 per share.

This discrepancy can be magnified if the investor continues to hold the ETF without rebalancing and the market volatility continues. Successfully using a leveraged ETF is based on betting on the right direction of the sector, and the path of the direction being relatively steady.

If the market is volatile, shorting one of these could theoretically allow you to capture the direction of your market call, plus the discrepancy in performance versus the index that will occur from the ETFs being rebalanced on a daily basis.

“I haven’t yet held a live short position in a leverage ETF position at all. I’m trying with a simulator with one of the discount brokerages to see how it’s going to work,” Banerjee says.

Banerjee says his discount brokerage will lend him The Horizons BetaPro S&P/TSX 60 Bull ETF at prime rate plus 1.5%.

“You can probably offset part of that by taking the short proceeds and buying a GIC or something,” Banerjee says. “If you have an opinion on the market — which everybody seems to — then instead of buying a leveraged bull ETF, you could short the bear [version]. You can have an opinion on the direction of market and still try to capture some of the excess leveraged returns in the direction on the market.”

For Banerjee, the value in experimenting with shorting serves as an educational process into explaining to retail investors the risks and opportunities with these very popular products.

“I don’t think anybody should go out and do this without researching and asking a lot of ‘what if’ questions,” he warns. “I don’t think a lot of people realized when these products first came out that if you bought and held the bull and bear version during what has been an incredibly volatile market you can lose a lot of money.”

This strategy will fall apart if the market trends in one direction. In that case, the leveraged ETFs will likely perform heavily in favour of the investor, says Howard Atkinson, president of Horizons BetaPro.

“Rebalancing on a daily basis is beneficial if a market trends. You’re going to end up with returns greater than two times, you’re going to get a compound effect. You’ll see returns going up and compounding daily,” Atkinson says. “There have been periods where we’ve seen four to six times the index return over a one year period because the market was generally in one direction. We’re giving you two times the leverage, but you never lose two times the exposure. We’re reducing the exposure as the market moves against you.”

What can get lost in the current wave of criticism of leveraged ETFs is that they’re structured as a way for investors to create portfolio hedges, without the expenses or complexity of managed futures and options contracts that were traditionally needed to create inverse exposure.

A portfolio needs to allocate only half the assets to get twice the hedging exposure to important portfolio asset classes, such as the main Canadian index or the price of oil. More importantly the portfolio doesn’t have to short those assets, so its downside risk is limited.

Again, these products have to be actively monitored. If the market reverses trends or becomes volatile, an investor will probably want to capture gains and rebalance the distributions.

For example, a popular trading technique is to use an inverse financial services ETF to offset the risk in long-only positions in financial stocks. If there’s a sustained downturn in financial stocks, the investor can take some of the profits from the inverse ETF and redeploy them into long positions in financial stocks.

There’s an increased risk with these products that exists during volatile markets, and it’s up to the investor to be aware of that risk and make sure they rebalance their exposure to these types of ETFs. Atkinson says his company has always been very clear on this.

“We’ve been trying to demystify how our products work. A lot of our critics are smart people, such as accountants, securities lawyers and chartered financial analysts, who are saying, “Hey guys look at how these products work,” Atkinson says. “And we’re saying, ‘yeah, we’ve always disclosed this. It’s basic mathematics.'”

(05/25/09)