Your Complete Guide to Index Investing with Dan Bortolotti

The Trouble With Leveraged ETFs

2018-09-06T18:19:19+00:00January 26th, 2010|Categories: ETFs and Funds|5 Comments

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.

Consider Horizons’ BetaPro ETFs, which 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 S&P/TSX 60 2x Daily Bull ETF (HXU) should go up 4%. If the index declines, the ETF will lose twice as much. The 2X Daily Bear ETF (HXD) works the other way around, delivering twice the inverse of the day’s returns: if the market drops 2%, the fund goes up 4%.

Canadians seem to love these so-called “leveraged” ETFs: some are among the most frequently traded securities on the TSX. But although they are often portrayed as tools for sophisticated investors, they’re really just speculative plays, suitable only for day traders looking to make a quick profit. If you’re an aspiring Couch Potato, you shouldn’t go anywhere near them.

Indeed, 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 2X Daily Bear 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 for a loss of $1.60. With a non-leveraged ETF that lost 2% and gained 2%, you would have lost only $0.40, or one quarter as much. Over long periods 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 (now called the BetaPro Gold Bullion 2x Daily Bull ETF (HBU)) 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.”

5 Comments

  1. 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!”

  2. 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.

  3. 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!

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

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

  5. Alain Guillot April 3, 2017 at 7:50 am

    Using leveraged ETFs may be a bad a idea, but using leverage to boost your return.
    Let’s say you use your margin account to boost your investment X1.25

    You invest $100,000 in the XIU with dividends of about 2%, You pay 4% interest on your margin of $25,000.

    You get $125,000 X 2% = $2,500 in dividends.
    You expenses are $25,000 X 4% = $1,000.

    You have enough to cover your interest expenses and your expenses don’t change with market volatility, they change with changes in interest rates.

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