Tue, June 30, 2009
Leverage and Exchange-Traded Funds Don’t Necessarily Mix: The Leverage Trap
I noted last week that the Financial Industry Regulatory Authority (FINRA) has warned brokers that inverse and leveraged ETFs are inappropriate for many retail investors. Having discussed the workings and problems of inverse ETFs, I’d like to continue by taking a look at leveraged exchange-traded funds.
FINRA’s warning highlights a point that I noted earlier: inverse and leveraged ETFs are designed to yield returns on a daily basis, but over longer periods of time, “their performance … can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period….” The notice demonstrated this effect using the performance of a couple of specific ETFs between December 1, 2008 and April 30, 2009. The Russell 1000 Financial Services Index fell 53 percent during this period. A leveraged ETF designed to give 3 times the daily return of the index gained 8 percent, while a leveraged ETF intended to yield three times the inverse of the return declined only 90% over the period.
How Leveraged ETFs Work
The goal of a leveraged ETF is to deliver (before fees) a multiple of the daily return of an index (e.g., for a “2x” ETF, if its index goes up 5%, the ETF goes up 10%) or, for inverse leveraged products, a multiple of the inverse of the return (if the index goes up 5%, the ETF goes down some multiple of 5%).
A leveraged ETF can be useful if you want to protect (“hedge”) against losses in a security you own; for example, you have $100K invested in an S&P500 index fund and want protection against losses for a day. For $50K, you could buy a 2x inverse ETF. If the S&P500 dropped 2% the first day, your index fund would be down $2,000, but your ETF position would be up by $2,000 (minus fees).
Leveraged exchange-traded funds generate their returns in various ways. They can invest borrowed money or use financial contracts, such as swaps, forward contracts, or futures that yield twice the index return. For the sake of illustration, let’s assume an ETF that functions by entering into 2 for 1 swap agreements with its counterparties. This is a “long” ETF, one with a price that goes in the same direction as its index (an inverse ETF would be “short”). In return for a fee, each counterparty agrees to pay the ETF $2 for every $1 increase in the index value; if the index declines in value, the fund will pay its counterparties on a 2:1 basis. This enables the ETF to deliver (or lose) twice the return of the index.
At the beginning of the day, the fund has $100,000 in investor assets and $200,000 in index exposure using 2-for-1 swaps. The index goes up 10%; the fund now has $20,000 more in net assets. If the fund closes the day without increasing its leverage, it will no longer be able to deliver a 2:1 return, so near the end of the trading day the fund has to boost its swap exposure by $20,000.
The fund starts the next day with $110,000 in net assets and $220,000 in swap exposure. That day, the index drops 10%; causing the fund’s assets to drop by $22,000. In order to return to a 2:1 ratio, the fund must reduce its swap exposure by $22,000.
Notice that when the market goes up, the leveraged ETF must increase its leverage, but this increases its loss if the market drops. By design, it’s forced to buy when the market goes up and sell when the market declines. In order to maintain constant leverage, it must tend to buy high and sell low. This effect is called a “leverage trap.”
Now consider an inverse leveraged ETF. When the market drops, the fund’s net assets increase, so it must add leverage and increase its short-sale positions. When the market increases, it must liquidate its short positions, which has the same effect on market prices as buying a long position. Consequently, at the end of an “up” day, both long and short leveraged ETFs must increase their long positions and both must sell on down days. This could have the effect of amplifying up and down days near the end of each trading day. This spring, the Wall Street Journal’s Jason Zweig noted that large banks and brokerage houses have begun speculating on the basis of the expected behavior of index ETFs. The speculators make trades in certain securities near the end of the day knowing that index ETFs must buy on up days and sell on down days.
On days when markets are especially volatile, traders piling on in the same direction as ETFs could lead to severe swings in market prices, although no one has shown that this has ever happened – yet.
Leveraged ETFs and long-term investing
A recent paper examined the extent to which the prices of leveraged ETFs associated with major indices have tracked the behavior of their indices over periods longer than a day. The paper, entitled ”Long Term Performance of Leveraged ETFs”, concluded that
For holding periods less than one month, leveraged “short” ETFs provided close to twice the inverse return of the underlying benchmark.
Over the course of a calendar quarter, cumulative returns of leveraged ETFs can deviate considerably from their short-term leverage targets.
Leveraged ETFs are not precise long-term substitutes for long or short positions.
Leveraged ETF producers are quick to point out that their ETFs are not supposed to replicate index behavior over periods longer than a day, and that’s true. But many investors (and even some financial magazine writers) don’t understand this and are mis-using these ETFs.
Inverse Exchange Traded Fund + Leverage = Double Trouble
In my earlier post I discussed the problems associated with inverse ETFs. A leveraged inverse ETF combines the risks associated with each types of fund into a single package, making these ETFs are thus even more inappropriate for most retail investors.
In spite of the complexities and risks of leveraged and inverse ETF products, the exchange-traded fund industry will keep creating them as long as there’s a market. One ETF vendor recently sought SEC approval for new ETFs that would provide 3x leveraged returns for the S&P500 (long or short, depending on the ETF). FINRA’s warning may rein in the inappropriate use of these products, but it may not have a large impact.
For a discussion of the use of leveraged and inverse ETFs in a portfolio, take a look at this webinar at IndexUniverse.com. If you don’t have a sophisticated understanding of the risks and proper uses of these products, be sure to seek professional advice for your individual situation before using leveraged and inverse ETFs in your investment portfolio.
RELATED POSTS:
Exchange Traded Funds 101 – Part 1
Exchange Traded Funds 101 – Part 2
Leveraged/Inverse Exchange-Traded Funds Draw FINRA Warning
MA Secretary of State Investigating Leveraged Exchange-Traded Funds
Brokerage Firms Distancing Themselves From Leveraged/Inverse ETFs
Some ETFs Are Scarier Than Others