ETFs can sharply boost earnings — or losses

(TIM LEE / RALEIGH OBSERVER)

Marginal understanding

To trade on margin, you need a brokerage account to borrow from the broker up to 50 per cent of the cost of an investment. This allows investors to leverage their money two-to-one to seek higher returns. Basically, they need less money to make more money — at least in theory. For instance, a trader can have $10,000 in a margin account and buy up to $20,000 worth of stock. If the investment increases to $22,000, the trader can sell the stock, repay the $10,000 and pocket $2,000 minus fees and interest costs associated with borrowing. Without the leverage, the trader would have only been able turn a profit of $1,000.

Of course, margin trading can also work against you. If that $20,000 trade drops to $15,000, a 25 per cent drop in value in the investment, that’s a 50 per cent loss for the trader, who only had $10,000 in the account. Usually, when a margin trade drops 25 per cent in value, the brokerage will make a margin call. The trader has to add more money to the account to make up for the losses or sell the investment at a loss. In some instances, margin traders can lose all of their money if the value of the investment falls 50 per cent or more. And they may end up owing even more because of fees and interest costs.

— Investopedia

Management has its costs, only they’re less with ETFs

Many investors are attracted to exchange-traded funds because they are lower-cost alternatives to mutual funds. The management expense ratio for an ETF that tracks the direction of the TSX 60 is a fraction of the cost of an equity mutual fund, for which the fund manager is picking stocks and using the TSX 60 as a benchmark of success. Furthermore, many investors believe index ETFs will turn out to be a better investment long term — even excluding management costs — because fund managers do not consistently outperform their benchmark index. Leveraged ETFs are also a low-cost option compared to using a margin account. Leveraged ETFs do have a cost higher than other index ETFs, but they are still cheaper than the average actively managed equity mutual fund that charges at least two per cent in Canada. Horizons S&P/TSX 60 Index ETF, which mirrors the performance to the TSX 60’s daily performance without leverage, has a management cost of 0.07 per cent, excluding taxes. The Horizons BetaPro S&P/TSX 60 Bull+ ETF — which uses leverage to get two times the daily performance — has an annual management cost of 1.15 per cent. Unlike margin investing, investors do not have interest charges associated with borrowing money — or as much risk.

Three times the fun. or pain

Risk hungry investors can buy triple-leveraged ETFs offered on the New York Stock Exchange. These investments offer three times — or three times the inverse — of the daily performance of an underlying index. Direxions Funds is the largest provider of triple leveraged ETFs, including offerings for emerging markets.

They’re not just for speculation

Horizons president Howard Atkinson says leveraged inverse ETFs can also be used to hedge risk for a portfolio. The advantage of leverage is you need less capital to hedge. The disadvantage is the ETF would have to be monitored frequently — almost every day — to ensure it still has enough capital to serve as a hedge to the portfolio.

Leverage is a word that evokes as much trepidation in advisers as it arouses visions of soaring returns in speculators.

Once the tool of investment banks, hedge funds and sophisticated speculators, it’s now available to anybody with an online brokerage account.

This is nothing new, in some respects. Retail investors with a bit of capital have always been able to borrow on margin to invest in a quest for higher returns. When they get their calls on the market right, leverage is great. But when they don’t make the right call, the opposite happens. They may lose most, if not all, of their invested capital. For this reason, many prudent advisers steer clients clear of leverage when investing for retirement.

But in the last five years, a new kind of investment has become popular with investors allowing them to use ‘L’ word — borrowing on margin to invest.

These are leveraged exchange-traded funds. Exchange-traded funds — or ETFs — are similar to mutual funds, only they’re bought and sold on a stock exchange. Most ETFs try to emulate — but not beat — the performance of an underlying index, like the S&P TSX 60.

Developed about 20 years ago, they caught on quickly because of their low-cost management and flexibility compared to mutual funds. As their popularity grew, so did the number of permutations offered by fund companies.

In 2006, two U.S. fund firms — ProShares and Rydex — launched leveraged ETFs, which offered two times the performance on an underlying index, or two times the inverse performance of the index.

In other words, you could double down with an ETF that an index — like the S&P 500 — would go up in value, or you could double your bet it would go down in value.

Shortly after that, Horizons Exchange Traded Funds offered its own bear and bull leveraged ETFs to Canadian investors.

And over the next few years, leveraged ETFs would become the most actively traded investments on the Toronto Stock Exchange, says Howard Atkinson, president of Horizons Exchange Traded Funds, the only firm providing leveraged ETFs in Canada.

Partly why these ETFs have become so popular is because they provide investors with exposure to leverage without all of the risks of using a margin account.

The vehicles are designed to give limited risk with non-recourse leverage to investors, he says.

Assuming these are not going to be held in margin accounts, you’re not going to get a margin call with a leveraged ETF because of the rebalancing of the risk profile daily.

In other words, the invested money is at risk, but you’re not going to have to keep putting money in to prevent having to sell at a loss.

Despite their apparent speculative nature, leveraged ETFs are a growing market for Horizons. The firm started out with two leveraged products in 2007 and now has 31 leveraged ETFs, accounting for $2 billion in assets.

Among the most popular are those tracking the commodity indices.

The highest interest for quite some time has been natural gas, and that would be followed by oil, and after that it’s the 60 index itself and gold stocks, he says.

While these products allow retail investors to use leverage with limited risk, investors also need to understand fully how leveraged ETFs work, says an analyst based in Chicago.

Morningstar’s Canadian ETF specialist John Gabriel says many investors have been disappointed by the leveraged ETFs’ performance, but it’s not because the products are faulty.

It’s the investors’ lack of understanding of the products that’s problematic.

The thinking is that if there’s a two-times product, I’ll just hold it for a long period and get double the returns, he says. That’s not the case with these products because they reset every trading day.

Leveraged ETFs emulate 200 per cent the daily performance — or 200 per cent the inverse, if it’s a bear ETF — of the underlying index. If the TSX 60 is up two per cent at the end of one day, the bull ETF leveraged version will have increased in value by four per cent.

Makes sense, right? But here’s where people often get confused.

They assume that over time, the product price movement will match the price movement of the underlying commodity or index when, in fact, the value of the ETF could vary significantly from the long-term price movement of the underlying index.

Winnipeg-based portfolio manager Alan Fustey says anyone considering buying and holding a leveraged ETF for longer than a day may be disappointed if they’re making a direction call on a commodity, for instance, for a longer period of time.

The daily return of an index is not the same as what the long-term return will be because of the compounding effect, says the managing director of Index Wealth Management, which specializes in ETF investment strategies.

Here’s how the compounding effect works.

If you buy $100 of an ETF that provides two times the daily performance of an index, and that index falls by 2.5 per cent, your investment falls by five per cent. The next day, the index goes up 2.5 per cent and your investment increases by five per cent. That sounds like you’re even, but you’re not. Five per cent of $95 is $4.75, so instead of being back at your initial investment, you’re still down.

The compounding effect can have an impact on all market investments, leveraged or not, but with leverage, the effect is amplified.

And the more volatility in the price movement — up and down — of the index on which the ETF is based, the greater the compounding effect will be.

The greater the volatility of the underlying index and the longer you hold the ETF, the more potential there is for the ETF price to drift from what you expect the return to be to what you’re actually going to get, Fustey says.

Gabriel says this phenomenon is called volatility drift and while it can work against you, it can also work in your favour.

If oil is going up like it was in June and July of 2008, when it was going up almost every day, the leveraged bull ETF is actually going to give you better than 2X, he says.

The problem is markets normally do not to behave that way. Still, money can be made with these products for those willing to take on the risks, and who understand them, says Atkinson.

That doesn’t mean you have to be a professional trader, but it’s not for someone who is buying it for their RRSP and then looks at it again next year.

The average investor, however, might want to think twice about investing in leveraged products, Fustey says. The products are too short-term in nature for most retail investors’ needs, and he says he does not use leveraged ETFs with his clients because they’re more like an educated bet than they are an investment.

It’s really a coin flip each day on which direction the markets are going to go, and on top of that, you’re leveraging that coin flip.

giganticsmile@gmail.com

Republished from the Winnipeg Free Press print edition May 7, 2011 B11