Investment Corner

Is there leverage in your investment vehicles; buyer beware?

Through January of this year, with the 10-year bull market in equities and historically low volatility, leveraged exchange-traded funds (or leveraged ETFs) and mutual funds exploded in popularity. Some investors who were late to invest during the early run of the current bull market missed the double digit annual returns of recent years, and thus turned to these instruments in hopes of magnifying returns and making up for lost time. Many investors, however, may be blindly putting their money into these vehicles without fully understanding how they work, how they should be utilized, and the associated risks.

A leveraged fund or ETF uses financial derivatives and some degree of debt in an attempt to enhance the returns of an underlying index. A typical leveraged ETF, for example, uses daily futures contracts to increase the exposure to a particular index. In layman’s terms, a leveraged ETF with a 2:1 ratio would match each dollar invested with an additional dollar. Theoretically, this would mean if the underlying index, perhaps the S&P, were to return 1% on any given day, the leveraged ETF should return 2%. Conversely, the same would occur on the downside in that if the underlying index decreased by 1%, the leveraged fund would expect to be down 2%. In addition to the performance of the underlying index, these funds may be subject to liquidity risk, and have higher than usual management fees to account for the intricate operations, derivatives, and borrowing interest needed to leverage the investments.

Many investors think leveraged funds amplify returns on a long-term basis. They are wrong, as the equity meltdown this February indicated. Leveraged funds are designed to enhance daily returns of their underlying benchmark and, according to Apexium partner and chief investment officer, Matt Marcello, “They should be used by sophisticated investors for short-term speculative bets on the underlying index.” Leveraged ETFs use of daily futures contracts which reset at the end of each day. Consequently, if these investments are held longer than one day, their performance may differ significantly from that of the underlying index multiplied by its leverage. The table below indicates the deviation that can happen over just a 3-day period:

Day Index Level Index Return (%) 2x Leveraged ETF Return 2x Leveraged ETF Level
1 100 0% 0% 100
2 92.5 -7.5% -15% 85
3 100.36 8.5% 17% 99.45
Difference +0.36 -0.55

Compounded over a normal investment period between quarterly or semi-annual reviews, the performance of the leveraged ETF can deviate further from the underlying index and be even more unpredictable. In fact, certain leveraged ETFs include the following disclaimer in their prospectus: For periods longer than a single day, the fund will lose money when the level of the index is flat, and it is possible that the fund will lose money even if the level of the index rises. Longer holding periods, higher index volatility, and greater leverage each exacerbate the impact of compounding on an investor’s returns.

Overall, leveraged ETFs represent a new and risky class of investments created to allow investors to amplify their bets on an underlying index. They can be a useful vehicle for a short-term sophisticated, speculative investor who wants to make a bet on the direction of an index over a day or two. Leveraged funds, however, should be used with extreme caution if not avoided outright by long-term investors. As always, portfolios should be reviewed holistically, be properly diversified, and carefully crafted to accomplish the financial goals of the investor.

 

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