ETF Risks in Perspective: Leveraged ETFs

This post is the second of three that will look at the potential risks that ETFs may pose to the stability of financial markets. Last week I discussed synthetic ETFs, which use derivatives called swaps to get exposure to their underlying indexes. Now we’ll examine leveraged ETFs.

Leveraged ETFs are designed to provide double or triple the daily return of their underlying index. The Horizons BetaPro S&P/TSX 60 Bull+ ETF (HXU), for example, promises twice the daily return of the popular large-cap Canadian equity index. If the index goes up 2% during the day, HBP will return 4%, and if the index loses 2%, the ETF’s return will be –4%. In the US, some providers even offer triple-leveraged ETFs, such as the Direxion Daily Large Cap Bull 3x Shares (BGU), which delivers three times the daily return of the Russell 1000 index.

A related family of products, called inverse ETFs, move in an opposite direction to the market. If Canadian large caps lose 2% in one day, the Horizons BetaPro S&P/TSX 60 Inverse ETF (HIX) will gain 2%, and vice versa. Many inverse ETFs also use leverage: they may rise 4% when the their index declines 2%, for example.

The problem

Since leveraged and inverse ETFs appeared in 2006, critics (myself included) have argued that these products are potentially harmful for individual investors who may not understand their risks. For an even-handed discussion of these risks, see Dan Hallett’s comprehensive report.

But the recent concerns about leveraged ETFs do not centre around poorly informed individuals. Rather, the US Securities and Exchange Commission is investigating whether these products have played a role in creating extreme market volatility, especially the huge swings we saw in early August.

Although these concerns have been around for a while, they got a boost from an influential October 10 article by New York Times writer Andrew Ross Sorkin. The piece included an interview with hedge fund manager Douglas Kass, who argued that “at the end of every day, leveraged ETFs have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted.” This flurry of trading, the article suggests, causes huge swings in the market during the final minutes of each trading day.

What Canadians need to know

Leveraged and inverse ETFs are primarily speculative products that have no place in a long-term investor’s portfolio. But there is simply no compelling evidence that these products pose a systemic risk—that is, that they cause market instability that affects all investors. Sorkin’s article offers nothing but vague suspicions: “Ask any hedge fund manager what their gut says,” is all we get. Let’s consider the other side of the argument:

They’re a tiny blip in the markets. Leveraged ETFs account for a mere 3% of total ETF assets in the US, while inverse ETFs make up another 2%, a market share that a Morningstar analyst called “a grain of sand on the beach.” It is hard to imagine that their rebalancing trades could be a primary cause of daily price movements. “Rather than focusing on leveraged ETFs’ supposed role in boosting market volatility, a more relevant examination would include options, futures and other financial products that increase leverage in the system, the analyst added,” says ETF Trends. “The size and scope of these markets dwarf leveraged ETFs.”

The tail doesn’t wag the dog. At the US Senate subcommittee hearing on October 19, Eric Noll of the NASDAQ presented an analysis showing that “trading in ETFs varies roughly in proportion with overall trading in the market. When news breaks and market prices move, trading volume increases in both the ETFs and the underlying stocks.” In other words, ETFs are responding to market volatility, not causing it. A Credit Suisse report echoed this argument: “We believe it’s a case of confusing correlation with causation.”

The world economy has a few other issues. Those who blame a tiny segment of the securities market for the recent market volatility seem to have forgotten that there are some serious macro issues in the world. As Eric Noll argued in his testimony: “Restricting or eliminating the [ETF] business will not solve the sovereign debt crisis in Europe, will not balance the US budget, will not restore bank balance sheets, will not add jobs, and will not repay consumer debt and get them spending again. There are very large, very real uncertainties that are driving global financial market volatility.”

If ETFs—leveraged or otherwise—are found to be contributing to market instability after a thorough investigation, I will be the first to support increased regulation. Until then, I’m inclined to echo the words of Dave Nadig of IndexUniverse. “There’s a big difference between being a niche, complex and sometimes misused product and being a threat to modern capitalism,” he writes. “Leveraged and inverse funds aren’t for everyone. In fact, they’re not for most people. They’re expensive, complex and require constant monitoring if held for more than a day…. But these funds aren’t the progenitors of some sort of global collapse.”

13 Responses to ETF Risks in Perspective: Leveraged ETFs

  1. Paul G October 31, 2011 at 10:37 am #

    You might want to clarify how the 3% and the 2% figures interact.

    Is the 2% two thirds of the 3%, or is it that 2% of that 3% are inverse, meaning 0.06% of the market is inverse ETFs ?

  2. Canadian Couch Potato October 31, 2011 at 11:44 am #

    @Paul G: The two numbers are exclusive of one another, so together leveraged and inverse ETFs make up about 5% of overall ETF assets. I made a change in the post to clarify.

  3. The Dividend Ninja November 1, 2011 at 10:17 am #

    WOW, what an incredible and well researched article!

  4. Superior John November 1, 2011 at 3:59 pm #

    An interesting article. A “niche” part of this complex market. What type of investor
    seeks to gain a livelihood out of this type of investing? Would he/she be considered a day trader?

  5. Canadian Couch Potato November 1, 2011 at 4:40 pm #

    @Ninja: Thanks, man. Or were you being sarcastic. :)

    @Superior John: Maybe not a day trader, but certainly a speculator as opposed to an investor. I would never recommend these products, just as I would not recommend shorting individual stocks, but that’s not the same as saying they are dangerous.

  6. My Own Advisor November 1, 2011 at 8:36 pm #

    Leverage = risk. That simple for me at least.

    Leveraged ETFs or anything else, leveraged, have no place in my portfolio. I doubt they ever will.

    Good stuff Dan.

  7. DM November 2, 2011 at 9:56 am #

    @CCP, Dan as someone mentioned in an earlier post you are doing the “investing public” a real service with this series. I don’t see this type of research and analysis on other blogs. I think you’re touching on topics that are very likely being hotly contested right now in the board rooms of ETF providers across the country. It wouldn’t surprise me if they are following this series (and probably others).

  8. Canadian Couch Potato November 2, 2011 at 4:10 pm #

    @MOA and DM: Thanks, guys, and glad you’re finding this series helpful. Yes, the ETF providers do follow these posts: in fact, I have contacted them during the research to clarify some issues. And if I make a mistake, my phone rings pretty quickly. :)

  9. Andrew F November 2, 2011 at 4:40 pm #

    CCP,

    An interesting issue is that most people (even ‘experts’ who appear on business news) don’t even understand where some of these ETFs go wrong. For instance, look at natural gas ETFs (leveraged and non-leveraged). The (bigger) problem with these funds is the contango in the futures market for the commodity, not just the tracking error resulting from daily resets of exposure.

  10. Chad Tennant November 3, 2011 at 11:38 am #

    Further to Dan’s piece and Andrew’s point, commodity leveraged ETFs using derivatives can be hazardous to a portfolio. Most investors are unfamiliar with the concept of “contango” or “negative roll yield”. A really good article from BusinessWeek explains the problem of Contango in depth. http://www.businessweek.com/magazine/content/10_31/b4189050970461.htm
    For example, as of Oct 31, 2011 oil for the year was relatively flat i.e. Jan 4 $91.50 – Oct 31 – $92.58. Horizons popular Oil ETF (HOU) was down 27.05% over the same period. Investors not realizing that ETFs of this nature are designed for short-term or daily use only will loose over the long-term.

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