The Trouble With Leveraged ETFs

January 26, 2010

Being a Couch Potato is about buying, holding and rebalancing over the long term. Exchange-traded funds are great tools for index investors, but not all ETFs are designed for Couch Potatoes. In fact, some are nothing more than gambling instruments.

Readers may have noticed that my list of Canadian ETFs does not include most of the offerings from Horizons BetaPro. That’s because many of the ETFs from this provider are radically different from those of iShares, Claymore and BMO.

Horizons’ so-called leveraged ETFs promise to deliver double the return of the index they track: if the Canadian stock market goes up 2% in a given day, the Horizons BetaPro S&P/TSX 60 Bull Plus should go up 4%. If the index declines, the ETF will lose twice as much. The Bear Plus ETF works the other way around, delivering twice the inverse of the day’s returns: if the market drops 2%, the fund goes up 4%. Canadian investors love these things: they are among the most frequently traded securities on the TSX.

In the hands of a professional, leveraged ETFs may be useful for managing short-term risk. They’re also ideal for speculators and day traders looking to make a quick profit. But if you’re an aspiring Couch Potato, you shouldn’t go anywhere near them.

Leveraged ETFs have taken a lot of heat, because many investors appear not to understand how they work. The funds are reset daily. So if you hold a Bull Plus ETF and the market goes down 2% today and up 2% tomorrow, you would not be back to even. A $1,000 investment would fall 4% to $960, and then gain 4% to $998.40. With a non-leveraged ETF that lost 2% and gained 2%, the loss would be one quarter as large, and over a long period that difference can become enormous.

I interviewed Norbert Schlenker of Libra Investment Management about these products for a recent article in MoneySense. “If markets went in a straight line, then these ETFs would simply be double bets one way or the other,” he explained. “But markets never go in straight lines; there is always volatility. And every time there is volatility, you give away a little more.

Last May, the Canadian Foundation for the Advancement of Investors’ Rights (FAIR Canada) released a scathing report demonstrating how volatility can affect leveraged ETFs if they are held for more than a few months: In March 2009, gold was up 1% from a year before, so if you had held Horizons’ COMEX Bull Plus Gold Bullion ETF during those 12 months, you might have expected to be up 2%. In fact, you would have lost 46%. Had you held the Bear Plus Gold Bullion ETF, you’d have lost 87%. No wonder FAIR called its report “Heads You Lose, Tails You Lose.”

Leveraged ETFs may behave as you expect over a few weeks or months, but they have no place in a long-term portfolio. “What is the purpose of your investing?” Schlenker asks. “Are you investing for the next two months? My clients are investing to fund their retirement, and these products, with that time frame, are poison. For retail investors, they are inappropriate in every circumstance. You may as well go to the casino.”

{ 4 comments… read them below or add one }

Cliff March 9, 2010 at 10:26 am

Well put. I see a lot of people calling Larry Berman on Berman’s call with questions about leveradged etf’s. Althogh Larry does advise against holding them long term, he should be telling callers to, “Stay away fom them!”

Raman March 24, 2010 at 2:55 pm

Nice post. However, there is a mistake in your calculations in the following sentence: “A $1,000 investment would fall 4% to $960, and then gain 4% to $998.40. (This would also be true for a non-leveraged ETF that lost 2% and gained 2%, but the loss would be half as much.)”

In fact, a non-leveraged ETF that lost 2% and gained 2% would have lost one-quarter as much, not half as much. This can be shown as follows:

(1-x)*(1+x) = 1-x^2
whereas
(1-2x)*(1+2x) = 1-4x^2.

Canadian Couch Potato March 24, 2010 at 6:35 pm

Thanks for spotting the error, Raman. I’ve corrected it above. It actually makes the argument a lot stronger!

Maxwell C. July 4, 2011 at 7:36 pm

I really love the little corrections that are oft added by math-whizzes here :-)

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