Leveraged ETFs are Risky Business
An investment product that has exploded in popularity this year is the leveraged ETF.
What the heck is that, you ask?
Well, ETF stand for exchange traded fund, and they are passive investment funds that you can buy and sell on the stock exchange throughout the day, like a stock. This is different than a regular mutual fund, which trades only at the end of the day at the exact value of its underlying assets at market closing.
An ETF’s price at any time is based on what the market will pay for it. This is partially a reflection of investor sentiment, although it is usually very close to the value of the underlying assets.
Most ETFs track an index, hence the term “passive” applied to the management style. This allows a very low management fee, in the range of 0.3% to 0.4%.
Basic ETFs have been popular for 15 years or so, and initially tracked the broad markets like the S&P TSX 300 in Canada and the S&P 500 in the US. Gradually, though, they became available to invest in much more focused indices, like the industry sub-categories, countries, emerging markets, small cap stocks, oil, gold, you name it.
So far, so good. These focused ETFs give nimble investors - who want to make a concentrated investment in a certain basket of securities and want to know exactly what they are buying – an opportunity to move in and out of those markets at will. More broadly diversified ETFs are also very useful for investors who might have been disenchanted with actively managed mutual funds, with their higher MERs. We have used ETFs effectively for years in our practice.
But last year, BetaPro Management Inc. decided to raise the ante substantially, by taking some 30 different leveraged ETFs that had been available in the US and introducing them to the Canadian market. These can be used to “place bets” on a market or a commodity (like oil) going either up or down. You do this by buying a “bull” or a “bear” version of the ETF.
As the name suggests, these instruments use derivative contracts to “lever” the returns, usually by a factor of two. This means that a 5% market gain would theoretically provide a 10% ETF gain. The really exciting part is that a 5% market loss would equate to a 10% loss on the ETF.
But wait, there’s more.
If you hold the leveraged ETF for more than one day, you don’t really know what your return will be. This is because of the marvels of compound interest, and the fact that the ETF starts life fresh daily, in terms of its compounding period. The ETF is internally rebalanced every day.
For example, let’s say that a $10 ETF invests in a market that goes up 10% in one day, providing the ETF investor with a 20% gain, or a new value of $12. You have to like that.
However, the next day the market declines 10%. Oops, we lost 20% of $12, or $2.40. Our ETF is now worth only $9.60. (The market itself is also down, as it lost more than it gained, but down only half as much.)
So, in a volatile market, the multi-day (or multi-week) return on the leveraged ETF could be very different than its underlying commodity or index.
Does this work in reverse? If the market lost 10% and the ETF lost 20% one day then they gained 10% and 20% respectively the next day, would your leveraged ETF be worth more than when you started?
A 20% loss reduces the $10 ETF to $8. A gain of 20% from there only gets you back to $9.60. It seems like heads you lose, tails the other guy wins.
The lesson is that these leveraged ETFs are very useful tools for short term traders - nimble investors who are adept at guessing the direction of a commodity or a market, and plan to buy and sell daily with quick profits (or minimal losses). The ETFs have advantages over the investor borrowing money herself, in terms of limiting risk. They can also track a market reasonably well if the returns are consistent and linear.
But for long term investors, what you see is often not what you get, especially in a volatile market. Be sure you understand how these things really work.
If much of what I have said today sounds like gobbledegook, then these are probably not an appropriate investment for your portfolio.
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David Christianson is a fee-only financial planner and investment counsel with Wellington West Total Wealth Management Inc.