Recent years have introduced a host of exchange-traded funds (ETFs) that let investors access asset classes in cheap and novel ways: iShares (Barclays) introduced funds of ETFs, Claymore launched a fundamental index fund, and Horizons BetaPro (Jovian) gained popularity with its leveraged bull and bear funds.

Investors have poured billions into ETFs. At the end of October, Morningstar’s database contained over 70 ETFs in Canada with $16.2 billion under management. It’s tough to keep up with innovation, and the financial engineering needed to create these complex products means investors don’t always understand the risks involved.

This is the case with the Horizons BetaPro ETFs. A look at the recent performance of certain funds indicates something isn’t quite right. For example, both the Bull and Bear versions of Horizons BetaPro Global Gold ETF – which are supposed to be mirror images of each other – are down substantially this year. They clearly haven’t performed as expected.

A closer look reveals some inherent quirks that can lead to significant deviations from the underlying index. There are different types of index funds and ETFs – those that hold the same underlying securities as the index, and those that create a synthetic portfolio with a similar return through the use of derivatives such as futures, forwards, options and swaps.

In Canada, Horizons BetaPro is currently the only provider of leveraged and inverse-leveraged ETFs. These use derivates in an attempt to match twice the daily performance of an index, which means their performance will differ from two-times the index’s performance over periods longer than a day. The risks to investors lie in the execution of the synthetic strategy.

Imagine two investors who bet on the price of Kryptonite, which is sitting at $100. The optimist invests in a two-times leveraged bull ETF, while his pessimistic counterpart buys units of the leveraged bear fund, each costing $100. The next day, Kryptonite moves up 10% to $110. Ignoring fees and transaction costs, for the moment, the bull fund rockets to $120, and the bear fund falls to $80. The day after that, Kryptonite settles back to its original price of $100, a 9.1% retrenchment. To double that move, the bull fund goes down 18.2% to $98.19, and the bear fund gains the same percentage, rising to $94.55. Kryptonite is the same price it was at the beginning, yet both investors have lost money, even before fees.

When ETFs are rebalanced daily, negative compounding creates a drag that increases with higher volatility. Conversely, a market that trends in one direction without fluctuating can cause ETFs to return more than their benchmarks.

Leverage exacerbates the effects of volatility, and over longer periods, it can penalize performance. For example, Horizons BetaPro estimates that before fees, a twotimes leveraged ETF tracking an index that’s flat on the year with 25% volatility will lose 6.1%. If there’s 50% volatility, it will lose 22.1%. Considering that the VIX, an index that tracks the implied volatility of the S&P500, is currently at unprecedented highs, it’s easy to imagine the serious harm a buy-and-hold strategy could suffer when invested in this niche product.

The upshot of having exposure to volatility is that you have to be correct not only on the direction of your investment, but also the path it takes to get there. When returns are extreme, volatility is usually high. This is dangerous because it makes ETFs prone to “perfect storm” macro events.

Other factors, such as fees and transaction costs, can cause an investor’s return to deviate from the movements of the underlying exposure.

Horizons BetaPro ETFs have a management expense ratio of 1.15%, which is low compared to most mutual funds, but significantly higher than many other passive strategies. Along with the management expense, Horizons BetaPro ETFs incur an expense on their forward contracts that ranges from 0.2% to 0.5% per annum, depending on the fund, plus the hedging costs incurred by the counterparty. The prospectus also lists a 0.25% discretionary redemption fee. When you add it all up, plus the incurred brokerage fees, these are expensive products.

ETFs trade on exchanges similar to stocks. Hence, during periods of heightened uncertainty, the bid-ask spread will often widen. This can result in orders transacting at prices that deviate from the net asset value (NAV). And for those funds that reference the price of a commodity, there is also basis risk, which is the risk that the price of the forward contract deviates from the spot price.

Despite the drawbacks, leveraged and inverse-leveraged ETFs have benefits. They offer nonrecourse leverage, which means the most investors can lose is their initial investment, despite essentially borrowing money to invest. And while short positions can theoretically incur unlimited losses, bear ETFs have limited liability. Many investors are also constrained in their ability to short, so inverse ETFs can solve this problem. They also provide access to areas of the market that would otherwise be difficult to invest in, such as gold bullion, natural gas and grains.

Leveraged ETFs are short-term instruments – the longer you hold them, the higher the chance they will underperform their underlying exposure. Institutions often use them to hedge temporary unwanted exposures. But to use them for speculation is dangerous, because consistently predicting short-term movements in commodities and equity markets is virtually impossible.

Longer-term, you would be better off with an ETF that actually holds the underlying securities rather than a synthetic exposure based on daily moves.

Al Kellett and Esko Mickels are fund analysts with Morningstar Canada.

Originally published in Advisor's Edge Report