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Leveraged ETFs let advisors who don’t have options licenses help investors hedge. But the fast-paced funds—holding times are generally a day—aren’t for every client.

“Most people don’t really understand them or have the ability to monitor them as closely as they should,” says Ottawa-based advisor Brent Vandermeer of The Vandermeer Wealth Management Group, HollisWealth.

Also sounding a note of caution is Michael Sapir, chairman of ProShares in Bethesda, Md.—the first company to sell leveraged ETFs, back in 2006. The products “are for more seasoned and knowledgeable investors,” he says.

When leveraged ETFs were first introduced, some institutional and sophisticated individual investors used them to hedge portfolios. Others invested in them based on whether they thought the day’s market would rise or fall, write ETF industry experts Joanne Hill, Dave Nadig and Matt Hougan in a guide to the funds commissioned by the CFA Institute.

Leveraged ETFs, also known as geared funds, aim to multiply a benchmark’s returns by two or three times. Common benchmarks include indexes, commodities prices and sectors. Leveraged bull ETFs aim to multiply a benchmark’s return, while leveraged bears multiply the inverse of the benchmark’s return. So if the S&P 500 goes down by 10%, a -2× S&P 500 bear ETF would go up by 20%, while a 2× bull ETF would be down 20%.

To achieve the multiplied returns, leveraged ETFs use futures, forward contracts, swaps and other derivatives. Some funds also hold the underlying securities or commodities; funds are rebalanced daily to ensure returns track the multiples promised.

Of the roughly $80 billion invested in ETFs in Canada, as of October 6, about $99 million is in leveraged funds, says Christopher Davis, director of manager research at Morningstar Canada. At 130 to 150 basis points, leveraged funds cost more than non-leveraged ones, he adds. By comparison, a non-leveraged S&P/TSX 60 ETF could have a fee as low as eight basis points.

Who are leveraged ETFs for?

Because gains and losses rack up quickly, leveraged ETFs should rarely be held for longer than a day (see “Regulator worries”). Further, a FINRA industry guide says leveraged ETFs are inappropriate for intermediate or long-term investors, and should only be used as part of sophisticated trading strategies.

The ideal user, Vandermeer says, is “someone who is using this portfolio as a speculative investment.” He adds that inverse funds are useful for investors who want a different exposure to the markets, “rather than just being long-only and assuming that markets will rise.”

When he’s determining suitability, he reviews how a geared ETF would fit into the rest of the portfolio, how much of the portfolio it would make up and how it would interact with other investments. He also makes sure clients understand how the products behave by explaining compounded returns and plotting them on a graph to clarify how the ETF will perform.

Other considerations are more personal. “What is the client trying to do with the portfolio?” he asks. “Can they handle the risk if that part of the portfolio doesn’t perform the way they thought?”

The suitability of leveraged ETFs for a client depends more on her motivation and less on how much she has to invest. “You can put an ETF trade through for a small amount of money,” he notes. Of Vandermeer’s 250 clients, two or three have leveraged ETFs. They have self-directed accounts and came to him asking about leveraged strategies.

“They say, ‘I’ve got this opinion on copper.’ Or, ‘The market is going to crash,’ ” he says. These clients have high risk tolerances, and believe in their market opinions so strongly that they’re looking for ways to magnify the returns they expect.

If a client is predicting a crash, Vandermeer asks her when it’ll happen. That’s where most clients stumble. “They say, ‘I don’t know, I just think it’s going to crash,’ ” he says.

Leveraged ETFs are wrong for such clients. “It’s a mismatch between the product and what they’re trying to achieve,” he says. “They might be right and the markets may drop in the next three months, but, if they’re using a leveraged ETF, they’re not going to get the performance they thought.”

CHART 1: Bear, bull and standard, The one-month performance of the S&P/TSX Composite Index compared to funds offering 2× and -2× the index’s daily returns.

He recommends using options contracts instead. An advisor with an options license could buy a put option that lasts for six months, he suggests.

Another strategy would be to short the client’s position, but that would require more capital than a put option. (More on the relative costs of these strategies later.) Both tactics avoid the multi-day return-drift pitfalls of geared ETFs.

Leveraged ETF strategies

Geared ETFs “are not by any stretch a total portfolio solution,” says Sapir. “But as an ingredient—a spice within a portfolio—for the knowledgeable investor, they can offer some opportunity.”

The CFA Institute guide outlines five main strategies for using leveraged ETFs.

01 Use the products to long or short an index, based on a prediction that the market will move in a certain direction in the short term.

This works for clients who expect a crash or a jump in the next day or two.

02 Use them to over- or underweight a particular part of an index, such as a sector or capitalization segment, so that you can leave the rest of the portfolio alone.

This is useful when an advisor believes the long-term outlook for the stocks in a client’s portfolio is positive, but also is concerned about a segment of the market, explains Sapir. The advisor wants to cover the client’s sector exposure without selling.

“Let’s say you’re concerned about technology, but you don’t want to dissect the portfolio and start trying to remove the exposure,” he says. “With an inverse technology fund, you could underweight that particular part of the market.”

If the client has little cash on hand, a leveraged ETF will magnify her underweight. For instance, a 2× or 3× bear ETF would double or triple the client’s inverse exposure without having to pay for it by selling other stocks.

03 Hedging or reducing risk for the short term (or for the long term with monitoring and rebalancing).

“If the market goes through a downward period, we might put a trade in that’s levered on the VIX,” says Vandermeer. “If you’re long the volatility side, you can typically make money while your long investments are going down.”

For an investor seeking a multi-day hedge, there’s a way to hold a geared ETF for that period, says Sapir. The advisor could rebalance the client’s holding of a leveraged ETF periodically by buying or selling some of the fund. Relative to the portfolio, this will keep the fund tracking its original 2× or 3× exposure, he says. But Davis notes the constant buying and selling “would be expensive and time-consuming, and the cost of execution would possibly outweigh any benefits.”

04 Designing an index-spread strategy to capture the relative returns of two indexes.

An advisor can use this strategy when she believes in a particular sector, such as healthcare, but not in the wider market or in another sector, such as consumer staples. “You could execute on that belief by being long the part of the market you believe in, and short the part of the market you don’t believe in,” says Sapir.

A leveraged ETF would amplify those positions.

05 Isolating an active strategy’s alpha from the market.

Sapir says this is a sophisticated strategy based on an advisor’s opinion of a particular manager. The advisor thinks the manager is effective at finding returns, but still expects the stock market to be weak. In that case, Sapir says, the manager “may still outperform the market, but the market may do so poorly that its performance causes you to lose money.”

To capture the manager’s performance, the advisor could buy into the actively managed fund while shorting the overall market with an inverse ETF.

“If you take your manager’s performance and you subtract the performance of the market overall, what you end up with is alpha,” he explains. A leveraged inverse ETF requires less capital than an unleveraged short ETF to achieve the same hedge, he adds.

The options option

Leverage is useful because it requires a smaller amount of capital to achieve the same effect as a larger unleveraged investment, says Vandermeer, but since the highest leverage available is 3×, its efficiency is limited.

For instance, if 20% of a client’s portfolio was long on an S&P 500 ETF, and an advisor wanted to hedge that risk with an unleveraged ETF, it would require another 20% of the portfolio to be sold and put into an inverse fund. Forty percent of the portfolio is now allocated to this one position. “That second 20% could have been doing something else,” he says. If the advisor decides to short the position instead, Vandermeer says it would take up the same 20%.

Using a 2× ETF would only require 10% of the portfolio—a more efficient allocation, but one that still uses 30%. If the advisor has concerns about the portfolio’s European and emerging market investments, for instance, she’d run out of capital before she could hedge every position.

This is where a put option makes sense. “Because one options contract represents 100 shares, you’d have to allocate less than 1% of the portfolio to neutralize that 20%,” Vandermeer explains. For instance, the SPY S&P 500 ETF was trading at $207.50 on Nov. 10. A 66-day put option on the ETF, with a strike price of $207, costs $5.60 per share. To hedge a client’s 20% long position in SPY would cost 2.7% of the position, or 0.54% of the entire portfolio, says Vandermeer.

The options present two drawbacks. First, the cost of the contracts can affect returns. If the market doesn’t fall as the advisor predicts, Vandermeer points out the put option would be worthless when it expires, losing the client however much it cost to buy.

“That can be a cost drag over time, as you may decide to put that insurance in place again,” he says. “What you’re hoping is that you’re paying that less than 1% premium for insurance, but earning more because your 20% long position keeps going up.”

Second, with a put option, an investor’s losses can be unlimited if the market rises. In a report on ETFs, the IMF says geared ETFs are popular because the most an investor can lose is her initial investment. “The cost of the unit you bought can go down to zero, but it can’t go past zero,” adds Vandermeer.

Volatility and leveraged ETFs

Investors may want to hold geared ETFs for longer than a day if they think the market is moving uniformly in one direction, says Sapir. “In a trending market, if you hold geared funds over a longer period and don’t rebalance your holdings, generally speaking the return will tend to outperform the daily target,” he says. So, under these conditions, a 2× bull fund would return more than double the index’s performance. In a volatile market, the opposite is true: “the return will tend to be less than 2× over time.”

If they’re held longer, Vandermeer says advisors should monitor these products daily. He uses the alerts in his market-tracking software to notify him if a product has moved 10% or more from his original purchase price, in dollars.

He also makes sure clients don’t keep leveraged ETFs for longer than a couple of days; he recently closed a position on a leveraged volatility ETF while it was down 4.5%, because volatility was falling and he expected more downside. “I looked at it and said, ‘Do I think markets are going to crash today, or will they be strong? They’re probably still going to be strong, so we have to get this volatility ETF out,’ ” Vandermeer recalls.

While geared ETFs are riskier than non-leveraged funds, their pitfalls are well-documented, says Sapir. “There’s a view that somehow geared funds are in a class by themselves, in terms of being for more sophisticated investors,” he says. But leveraged ETFs aren’t the only risky ETFs, he argues. Other ETFs, for instance, expose investors to currency, regulatory and macroeconomic risk. “Unless you understand the individual risks of what you’re buying, you shouldn’t buy it,” he says.

Regulator worries

The SEC and FINRA, along with the CFA Institute, are concerned retail investors are buying geared ETFs without understanding them. They’re as accessible as non-leveraged exchange-traded investments, and regulators say some investors don’t appreciate that losses can add up quickly.

“Compounding in leveraged funds can result in gains or losses that occur much faster and to a greater degree,” states CFA’s ETF guide.

Take the example of an investor who buys a unit of an S&P 500 -2× bear ETF for $100. That day, the index goes up 10%—a $100 unit of an unleveraged ETF would now be worth $110. The inverse ETF loses 20%, and is now worth $80. So far, the product is working exactly as the investor would expect.

But if the investor decides to hold his share an extra day, without understanding the consequences, he may be surprised at the result. On day two, the market goes down 9.09%, bringing the unleveraged share back to $100. The bear ETF recovers, but not completely. It goes up 18.08%, to $94.55, so it’s still posting a loss.

The longer the investor holds his leveraged ETF, the further it drifts from its objective and the return of its underlying security. This effect is worse in volatile markets, notes the SEC. For this reason, advisors and fund companies say these products should rarely be held for longer than a day—a warning that’s bolded in their prospectuses.

Between July 1 and September 30, the S&P 500 was up 4.6%, while an S&P 500 2× bull ETF was down 14%, says Morningstar’s Christopher Davis. “Here we are in a situation where the index made money, yet the leveraged bull ETF lost quite a bit because it was a very volatile three months,” he says.

Jessica Bruno is content editor at Advisor Group. Reach her at jessica.bruno@rci.rogers.com or on Twitter, @JessicaNBruno.

Originally published in Advisor's Edge Report

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