Are leveraged ETFs smart investments?

This article is current as of November 2011.

Are leveraged ETFs smart investments or fast ways to lose money?

ScotiaMcLeod advisor Peter Lambert describes an ETF as a “duckbilled platypus—it has qualities of stocks and mutual funds. It gives investors exposure to a variety of stocks that comprise an index, and provides a passive investment vehicle that is designed to follow the movement of an index.”

Leveraged ETFs take the idea of an ETF one step further. Instead of providing an investment return that mirrors the index performance benchmark, an LETF tries to achieve a multiplier of the daily performance of the index, usually double or triple. And, to achieve this, they employ derivatives, futures and options to achieve the investment goal.

“Leverage magnifies returns and losses,” notes Jaime Purvis, executive vice president, national accounts for Horizons Exchange Traded Funds. “Clients need the appropriate risk tolerance to make sure they are comfortable with the risk.”

The investment goal of an LETF is to provide a multiplication factor to the daily performance of the index it follows, usually two or three times. “These ETFs are designed to deliver two times the daily performance of their benchmark,” says Purvis. “The majority of these ETFs have a correlation to the benchmark of 0.9999%, essentially perfect. An LETF’s investment objective is limited to daily returns in order to ensure that the investor can never lose more than his or her principal investment.”

Bull LETFs seek to provide two or three times the performance of an index, while Bear LETFs seek to provide two or three times the inverse performance of an index benchmark. “Inverse ETFs allow you to profit from negative price movement in an asset class,” Purvis says. “Those movements can be substantial. In fact, the best-performing ETF in Canada over the last three years has been an inverse LETF.”

Daily reset of the LETF can have a significant impact on the investment. “Many clients hold LETFs for a longer period than they are designed for,” says Oliver McMahon, former head of product development for iShares. He attributes this to investors’ misconceptions.

“People believe LETFs give this leveraged return over a multi-day period, and they invariably don’t. These products are designed to [be held] for a short period—you should only own these intraday. Few people can outperform the marketplace by owning these products over a multi-day period.”

Lambert adds the LETF may not track the index exactly if there is a great deal of volatility in the underlying index. “These vehicles should be treated with a short timeframe in mind. With double or triple, you can lose your money very quickly, although you can only lose what you initially invested. A lot of people really don’t understand these things.”

If people invest in LETFs and don’t understand the daily reset, the capital can be eroded very quickly. “These are a short strategy investment. It’s a hard concept for most investors to understand.”

(See the examples below for a breakdown of how an LETF works.)

For example, Client A buys 1,000 units in an LETF that provides 2 times the benchmark.

	UNIT OPEN	MARKET PERFORMANCE	FUND PERFORMANCE	UNIT CHANGE	UNIT CLOSE
Day 1	1,000	-10%	2 x -10%	-200	800
Day 2	800	-10%	2 x -10%	-160	640
Day 3	640	+20%	2 x 20%	+ 256	896

Client B buys 1,000 units in an Inverse LETF that provides 2 times the benchmark

	UNIT OPEN	MARKET PERFORMANCE	INVERSE FUND PERFORMANCE	UNIT CHANGE	UNIT CLOSE
Day 1	1,000	-10%	2 x 10%	200	1,200
Day 2	1,200	-10%	2 x 10%	240	1,440
Day 3	1,440	+20%	2 x -20%	-576	864

“It’s absolutely essential that the LETF’s investment objective is limited to daily returns to ensure that the investor can never lose more than their principal investment,” Purvis says.

In order to achieve the stated investment objective, LETFs often employ derivatives, futures and options, which Purvis acknowledges adds a layer of complexity to understanding their operation.

Composition of index

Diane McCurdy of McCurdy Financial in Vancouver says advisors need to do their homework before recommending LETFs.

“If you can’t explain the investment in simple terms, you either don’t understand it well enough, or the investment is outside of the client’s risk profile.” She says the transparency of ETFs is a good thing, but some advisors don’t look closely enough at the companies that make up the index, especially when dealing with global LETFs.

“There may be only a handful of companies in the index for a global LETF, and it can be difficult to find information about them.” She notes a typical prospectus for an LETF is five-to-eight pages, and the use of derivatives makes them complicated for the average investor.

Further, both clients and investors don’t always understand the impact of the daily reset on the investment. “The number one rule of investing, in a client’s mind, is don’t lose the capital. With the aging population, they may not have time to earn it back.”

Comparison of ETFs versus LETFs

ETFs	Leveraged ETFs
Lower MER compared to mutual funds Investment objective to mimic performance benchmark of stock market index	Lower MER compared to mutual funds Investment objective to provide a multiplier usually two to three times of the daily performance benchmark of stock market index
Allows intraday trading (stock price as at transaction price), rather than end-of-day settlement price	Allows intraday trading (stock price as at transaction price), rather than end-of-day settlement price
No daily reset	Daily reset of exposure to the index in fund to allow for rebalancing
Transparent investment. A list of stocks that comprise the index is readily available	Transparent investment. A list of stocks that comprise the index is readily available
Market maker does in-kind transfer of stocks to provide creation units. No impact on NAVPS of fund.	Market maker does in-kind transfer of stocks to provide creation units. May also use cash, derivatives, options and futures to meet daily performance objective. No impact on NAVPS of fund.
N/A (no daily reset)	Non-recourse leveraging. Most an investor can lose is initial capital investment.
Usually no drawdown or return of capital distributions to investors — only tax implications are usually capital gains	Usually no drawdown or return of capital distributions to investors — only tax implications are usually capital gains

Investment rationale

Purvis says advisors need to have a clear investment objective for the client before recommending LETFs.

“If you want to eliminate the market risk of a portfolio, you can take an inverse position on the market and use the ETF as a hedge,” he says. “An inverse leveraged ETF allows you to use half the capital to get twice the hedging position, making it an effective hedging tool for many portfolios.”

And, since most investors have a buy-and-hold philosophy, adding LETFs to a portfolio means the advisor will have to do a lot of explaining. McMahon says investors need to refrain from holding LETFs over multiple days, and need to fully understand the daily reset and balancing that goes on.

“For the right investor, leveraged ETFs can be the Tabasco to add spice to the portfolio. The problem is, not everyone can take the heat,” says Lambert.

Lisa MacColl is an Ontario-based financial writer.