EXCHANGE TRADED FUNDS

Speculating on these complex financial instruments can be dangerous

Don’t be tempted to speculate on a volatile market with these instruments, writes PETER GUY. Your losses could simply mount

Recent tumultuous events – the sudden drop in oil prices and the appearance of the global coronavirus outbreak – have generated a level of market declines and volatility that hasn’t been experienced in more than a decade. Worst of all, these conditions tempt investors to bet on the next direction or short-term move in the market through exotic products.

One of them is leveraged exchange traded funds (ETFs). They sound as if they merely track the market like normal (unleveraged) ETFs. But they are risky instruments that investors – especially high-net-worth individuals who like to speculate – should be careful of when volatility swings sharply in both directions based on panic and emotion.

A leveraged ETF is a marketable security that uses financial derivatives and debt to magnify the returns of an underlying index. While a conventional ETF typically follows the securities in its underlying index on a one-to-one basis, a leveraged ETF may be designed to amplify those moves on a 2:1 or 3:1 ratio.

Many such instruments are branded with sophisticated names like “ultrashort”, “double long” or “inverse”. They feature the transparency of information and tracking demonstrated by other ETFs, strict regulations and specialised index support and tracking by reputable sponsors.

They initially look like traditional ETFs, offering a way to exploit a market direction except using leverage to enhance a high-conviction trade. They imply the potential of double or even triple returns. Yet many investors are bewildered and disappointed when their leveraged ETF plays lose money, even if they bet on the right direction of the underlying index.

Investors usually begin with logical intentions. For example, they’re convinced that oil prices will rise by 25 percent over the next several months after their recent collapse. They search for and find a leveraged ETF that claims to produce two or three times an oil index’s return. And the ETF’s prospectus and marketing materials claim to produce daily leveraged returns of the index.

However, the key functional and risk word is “daily”. A leveraged ETF is repositioned at the daily close of market, which means the fund provider will rebalance the assets to align the fund with the new composition of the market. The provider promised to provide leveraged returns and it must take positions – adjusted daily – for it to pay out on this commitment. It cannot be caught off track if the market moves against it. But every time the oil index drops, the base for returns also falls. The leverage basis for returns is greater on the downside than it is on the upside, because the market moved against you.

Here’s an example of a three-times leveraged long ETF linked to an oil index. Say the oil index falls 5 percent in a single day. An initial $100 investment in the ETF would take that 5 percent drop and multiple it by three for a loss of 15 percent (or $15).

The ETF is now worth $85. Say the oil index then goes up 5 percent back to its original level. The investor is entitled to a leveraged 15 percent gain, but now the base for calculations is $85. Fifteen percent times $85 is $12.75, leaving the fund with a value of $97.75, and the investor out of pocket by $2.25.

Basically, returns are greater on the downside than they are on the upside. It just takes one move downward to throw the trajectory and base of your returns way off. In the above example, even though the index is flat for two days, the ETF’s net return is negative.

The more volatile the market is, the more exaggerated this tendency is towards negative returns. And, given the recent gyrations seen in global equities and oil, that observation does not bode well for the returns of leveraged ETFs.

But, remember that increasing

leverage from double to triple only amplifies the erratic and unpredictable outcomes. In reality, no market or index rises or falls smoothly over any period. Daily trading results are often choppy. Even if an index meets your target result over the investment period, the daily volatility will have produced losses on your leveraged ETF valuation.

And because the daily rebalancing of assets means a leveraged ETF provider has to buy when the market is going up, and sell when the market is falling, the cost of maintaining these positions is high. Leveraged ETFs have substantially higher management fees than unleveraged ETFs.

Ironically, the investor would make a loss even if his view and target were eventually correct. The problem is that

Even if an index meets your target result over the investment period, the daily volatility can produce losses on your leveraged ETF valuation

the investor simply cannot predict the exact path to his goals. The reason is that leveraged ETFs are very difficult to manage if you hold them beyond their daily rebalancing period.

There’s nothing inherently wrong with leveraged or inverse ETFs; actually, they do exactly what they’re designed to do – track the daily change in indices. But a fatal inconsistency exists in any long-term investment or portfolio hedge because of the mismatch between it and the portfolio. The daily rebalancing of their constituent portfolios eventually erodes the returns of even what appeared to be a smart trade.

There are ways of avoiding this daily rebalancing problem. Individual investors can lever up through use of a margin account, shorting an unleveraged ETF or using index options. Don’t get trapped in an inappropriate trade.