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The Risks of Leveraged and Invers ETFs

Summary

This article describes the main drawbacks of the performance of leveraged and inverse exchange-traded funds. These instruments are popular for their apparent high performance, but they involve major risks in the long term. So much so, that these products should preferably be traded on a daily basis and for speculative purposes only.

Leveraged and inverse (leveraged or not leveraged) exchange-traded funds are also called ETFs with futures contracts because they are composed mainly of derivatives rather than real products. Leveraged ETFs (also called “ultra long” funds) seek to deliver multiples of the performance of the index or benchmark they track. Inverse ETFs (also called “short” ETFs) aim to deliver the opposite of the performance of the index or benchmark they track. Inverse leveraged_ETFs (also called “ultra short” funds) seek to deliver multiples of the opposite performance of the index or benchmark they track.

An example of a traditional ETF is the XIU, which has the S&P/TSX60 as its underlying index, traded on the Toronto Exchange.

An example of an ETF with futures contracts is the HXU, of which one of the components is the SXF, a futures contract (in other words, a derivative) on the S&P/TSX60 index, traded on the Montréal Exchange.

Because of their synthetic structure, leveraged and inverse ETFs present specific risks, totally different from – and far more complex than – those linked to traditional ETFs. The drawbacks can be highly unpleasant. Any investor in this type of instrument has experienced situations similar to this: an index rises 2% over several months, but its leveraged ETF falls 7% over the same period. Or an index falls 2% in a few months, but the inverse ETF loses 25%, instead of an expected gain.

Here are the main drawbacks of leveraged and inverse (leveraged or not leveraged) ETFs:

The yield risk

An investor purchases a unit in a double long ETF for $100. The underlying index goes up 10% the same day: the investment is now worth $120. If, the next day, the underlying security loses 10%, the investor loses 20% of $120, or $24. The value of the account falls to $96. This means that, because of market fluctuations, an investor who holds his position over several sessions ends up losing. To keep the first day’s gain, he must close his position in the same session.

Daily “resetting”

Leveraged and inverse ETFs are unstable instruments, meaning that the ability, for example, to double the gain of the index is not permanent and constant. In fact, once a day these instruments must be rebalanced by the issuer to return to the double speed. The daily rebalancing does not guarantee either that in the course of the same day the property of doubling gains will remain constant.

Risk linked to the underlying product

An investor who chooses, for example, an ultra long or short ETF on natural gas does not face the same risk as someone who invests in a Canadian stock index, such as the S&P/TSX60. A hurricane in the Gulf of Mexico may affect the price of oil, just as a drought in Australia can lead to a lower worldwide grain harvest, and so on, without affecting the price of the Canadian stock index.

The leverage risk

An investor who selects leveraged and inverse leveraged ETFs incurs a risk of leveraged losses.

The risks implied in the constituents of ultra long, short and ultra short ETFs

The managers of these ETFs construct financial products using derivative products. Because of the variety and complexity of derivatives, the correlation between the performance sought by the managers and the performance actually obtained may often be flawed.

Conclusion

Leveraged and inverse ETFs can be compared to moving targets. To limit the risks and maximize the profit, it is strongly advised that these instruments be used only on a daily basis, which is the only timeframe in which the expected performance has the maximum probability of being achieved.

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).