UPDATED: Leveraged ETFs small but risky

Leveraged ETFs are a small part of the financial system, so they’re unlikely to cause a market crash. But they’re still risky to investors and asset managers, say industry players.

The products, which are designed to multiply investors’ typical returns, have come under fire from BlackRock CEO Larry Fink.

During a Deutsche Bank investment conference in New York on May 28, Fink said leveraged ETFs threaten the market’s structural stability and could “blow up” the funds industry.

Fink added that BlackRock would never sell a leveraged ETF and he doesn’t think the U.S. Securities and Exchange Commission should let them exist.

Traditional ETFs track indexes and offer lower fees than mutual funds because they require less portfolio oversight. As they’ve gained in popularity, firms have introduced more complicated versions, including products with leverage. Fink says these should be more closely supervised.

With $30 billion sold globally, leveraged ETFs are niche, says Howard Atkinson, CEO of Horizons ETFs. The largest category of these ETFs is based on the S&P 500, he says, and totals $5 billion.

“To put that in context, the current market capitalization of the S&P 500 is $17.6 trillion. So leveraged ETFs represent a whopping 0.03%,” he explains. “It’s a remote possibility at best that leveraged ETFs are going to move the markets and cause systemic risk.”

Of the $66 billion invested in ETFs in Canada, 1.5%, or more than $1 billion, is in leveraged products, says the Ontario Securities Commission.*

As such investments are a small proportion of the market, they’re unlikely to make waves, says Deborah Frame, vice president of investments and chief compliance officer at Cougar Global Investments, which manages non-leveraged ETF portfolios.

But they still have inherent risks.

In a low-volatility market, an investor with a leveraged ETF stands to either make or lose approximately twice the returns or losses of the referenced index. In more volatile situations, both returns and losses could far exceed that threshold.

“Inverse and leveraged [products] are a small part of the ETF industry, but I would say that they get outsized attention when things go wrong,” says Noel Archard, head of BlackRock Canada. “That can tarnish the reputation of the ETF industry as a whole—which is why we made the decision that we wouldn’t launch them.”

Read: Horizons launches swap-based bond ETF

Horizons is the only Canadian leveraged ETF seller. Atkinson says leveraged ETFs survived the financial crisis, and since then, regulators have also tightened the rules governing those products.

The OSC puts leveraged products into a special investment category, called commodity pools. It requires manufacturers put special risk warnings in prospectuses, and dealers must meet higher proficiency requirements.

“The proficiency levels contribute to a higher bar; I don’t think that prospectus disclaimers necessarily do,” says Archard. “How many people really look at a prospectus in detail before they hit the buy button?”

Archard adds BlackRock wants regulators to implement more prominent warnings, so that investors are well-informed before purchasing leveraged ETFs.

The OSC has also limited a product’s leverage to twice the initial investment. In the U.S., higher leverage multiples are allowed.

Bloomberg reports that in 2011, Fink compared leveraged ETFs to mortgage-backed securities. Frame points out that these products have an advantage over MBS: transparency.

“In 2008, we had no way to measure the leverage in the underlying system because it was in places where you don’t account for it,” she says. “It is an advantage that all [leveraged] ETFs have to document it.”

Read: Safety measures for swap-based ETFs

Still, BlackRock isn’t not the only institution concerned about complicated ETFs. The International Monetary Fund says European ETFs with derivatives complicate the market and add risk.

It’s the nature of the financial markets to be complicated and risky, counters Atkinson, who adds leveraged ETFs aren’t suitable for everyone.

They’re “very suitable for investors who have a particular view on an asset class, and they want to express that view. And they want to maximize their exposure to that view with the capital they’re putting up,” he says. “These investors must monitor their positions on a regular basis.”

Archard agrees that some clients, including institutional investors, have used leveraged ETFs well, but he’s still concerned about retail investors. Since the funds are traded on an exchange, companies can’t control who buys them. “That’s the risk: people using these products who don’t understand what they’re getting.”

Read: Different ways to construct ETF portfolios

In the U.S., BlackRock is lobbying for regulators to create categories of ETFs with clear labels and risk profiles. Atkinson suggests this push is to deflect regulators from categorizing BlackRock, one of the biggest asset managers in the U.S., as too-big-to-fail.

“He’s pointing the finger for regulators and steering them in the direction of products,” says Atkinson, “and not at the large asset managers, where there’s a movement of lawmakers and regulators who are concerned with systemically important financial institutions.”

Archard says regulators should look at regulating products and not firms.

“Historically, products with leverage embedded in them—not just ETFs but generally—have caused issues in the industry,” he says. “That’s where the concern is and that’s where the focus is. This isn’t about deflecting.”

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*The original version of this article stated Canadian leveraged ETF investments total 6%, or nearly $4 billion, of the $66 billion invested in ETFs in Canada. The source has corrected the statistic. Return to the corrected sentence.