May 2013

ETFS: The pull of leverage

PullieExchange-traded products that use leverage are a way of coping with flat markets. But Nick Fitzpatrick finds compounding risk means more attention needs to be paid to performance. In their hunt for yield in a low-return environment, investors to whom leverage has not become a dirty word have the exchange-traded product (ETP) at their disposal. ETPs, which include the exchange-traded fund (ETF) and the exchange-traded commodity (ETC), count about 113 leveraged products among their number in Europe. Though they can magnify returns, the health warning with leverage has always been that it can significantly increase losses. In particular, regular rebalancing means compounding will affect leveraged ETPs, detracting from returns in a volatile environment. Though losses are limited to the amount invested, for some people leveraged ETPs could be a sign of the industry’s excessive expansion in recent years. Yet for others, they help combat flat market returns and are useful hedging tools. Two leveraged ETP providers – ETF Securities and Boost ETP – tell Funds Europe about their experiences with these products, which typically employ 2 times or 3 times leverage.   ETF SECURITIES Nicholas Brooks, head of research and investment strategy ETF Securities offers 36 commodity products that are 2 times leveraged and 28 foreign exchange products with 3 times exposure. There are also six equity products with 2 times and -2 times exposure. The company says during periods of volatility, leveraged products have seen significant inflows as investors look to maximise exposure to short-term market fluctuations. In the two weeks after the sharp devaluation of the yen at the beginning of April, for example, ETF Securities saw a total net inflow to all its 3 times yen products of $4.4 million (€3.4 million), equal to 53% of net inflow all last year. In the three days following gold and silver’s large sell-off, net inflows were over $24 million into its leveraged gold and silver ETPs – 30% of net inflow last year. How does creating a leveraged ETF differ from creating a vanilla ETF?
The only difference is that in order to provide leverage the leveraged index must be rebalanced regularly (daily in the case of ours) in order to provide a continuous trading security. This rebalancing means that the returns from a leveraged ETF will be affected by compounding. However, just like our vanilla ETFs, investors cannot lose more than their initial investment and the ETFs are fully collateralised, limiting counterparty risk – unlike many other leveraged instruments such as spread betting, contracts for difference, investing on margin and structured products. Are there any basic guidelines for investors that use leveraged ETFs?
Because leveraged ETFs must rebalance on a regular basis to provide continuous trading for investors, they are affected by compounding. If the underlying asset performance trend is relatively smooth then the compounding will add to returns over time. On the other hand, if the underlying asset performance trend is very volatile, compounding can detract from returns.  Therefore, for investment horizons beyond one day for a daily rebalancing leveraged ETF, total returns will be affected by compounding as well as the leveraged return of the underlying asset.
Investors in leveraged ETFs, therefore, need to monitor their investments frequently, and beyond investment horizons of one day need to monitor the volatility of the underlying asset returns. If a market, or sector, increases (or decreases) 1%, should we always expect a 2 times leverage ETF to increase (decrease) 2%?
Yes, over the period up until the ETF or index re-balances. As most leveraged ETFs rebalance on a daily basis, after one day of trading, the returns will also be affected by compounding which can add to total leveraged returns if the returns of the underlying asset are relatively smooth and detract if the underlying asset performance trend is volatile. BOOST ETP Nik Bienkowski, co chief executive officer Boost offers 3 times short and 3 times leveraged ETPs including ETPs tracking five equity and five commodity indices for a total of 20 ETPs. Trading has primarily focused on the FTSE 100, German equities, gold, silver and, recently, natural gas. Flows have been seen into short gold and short silver since these metal came under pressure after a decade-long bull market. Bienkowski says that some investors use the ETPs in hedging strategies. For example, if an investor wants to protect a £100,000 (€118,000) position in UK equities against a perceived fall, they might purchase £33,333 of Boost FTSE 100 3 times short daily ETP. In this case, if the market falls, they lose on their equity portfolio and gain on the Boost ETP. Conversely, if the market rises, they gain on their equity portfolio and lose on the Boost ETP. How does creating a leveraged ETF differ from creating a vanilla ETF?
Creating a leveraged ETP is not too different from creating a plain vanilla, unleveraged ETP.  The products are quite similar operationally and in appearance: they are open-ended, transparent, collateralised with the assets being held by an independent custodian, track a passive index, are exchange-traded, and can be traded with multiple market makers.   In addition, we had to set up a bankruptcy remote vehicle in a suitable jurisdiction, such as Ireland, which is a leading domicile for European funds. The main difference is that with a leveraged ETP, the potential gains and losses are magnified, and also the way a daily leverage index works is slightly different to how an unleveraged index works. Are there any basic guidelines for investors that use leveraged ETFs?
Leveraged ETPs are complex in that short and leverage daily returns work slightly differently to unleveraged returns over longer periods because of the compounding and volatility.  It is important to understand how this works and in what scenarios this can benefit or hinder expectations. Certainly, any leveraged investment should be monitored regularly, if not daily, and generally, 3 times short and 3 times leverage ETPs are used for shorter term investment horizons.   If a market, or sector, increases (or decreases) 1%, should we always expect a 2x leverage ETF to increase (decrease) 2%? If the underlying index increases or decreases 1% in one day, then a 3x leverage ETP will rise by 3% of fall by 3% on that same day, ignoring fees and adjustments which on a daily basis are negligible. Over longer periods, a 3x leverage ETP’s return will be dependent on each day’s return. Generally for short periods, the returns of a 3 times leverage ETP approximate three times the index return. ©2013 funds europe

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