“It’s absolutely essential that the LETF’s investment objective is limited to daily returns to ensure that the investor can never lose more than their principal investment,” Purvis says.
In order to achieve the stated investment objective, LETFs often employ derivatives, futures and options, which Purvis acknowledges adds a layer of complexity to understanding their operation.
Composition of index
Diane McCurdy of McCurdy Financial in Vancouver says advisors need to do their homework before recommending LETFs.
“If you can’t explain the investment in simple terms, you either don’t understand it well enough, or the investment is outside of the client’s risk profile.” She says the transparency of ETFs is a good thing, but some advisors don’t look closely enough at the companies that make up the index, especially when dealing with global LETFs.
“There may be only a handful of companies in the index for a global LETF, and it can be difficult to find information about them.” She notes a typical prospectus for an LETF is five-to-eight pages, and the use of derivatives makes them complicated for the average investor.
Further, both clients and investors don’t always understand the impact of the daily reset on the investment. “The number one rule of investing, in a client’s mind, is don’t lose the capital. With the aging population, they may not have time to earn it back.”
| ETFs | Leveraged ETFs |
|---|---|
| Lower MER compared to mutual funds Investment objective to mimic performance benchmark of stock market index |
Lower MER compared to mutual funds Investment objective to provide a multiplier usually two to three times of the daily performance benchmark of stock market index |
| Allows intraday trading (stock price as at transaction price), rather than end-of-day settlement price |
Allows intraday trading (stock price as at transaction price), rather than end-of-day settlement price |
| No daily reset | Daily reset of exposure to the index in fund to allow for rebalancing |
| Transparent investment. A list of stocks that comprise the index is readily available |
Transparent investment. A list of stocks that comprise the index is readily available |
| Market maker does in-kind transfer of stocks to provide creation units. No impact on NAVPS of fund. |
Market maker does in-kind transfer of stocks to provide creation units. May also use cash, derivatives, options and futures to meet daily performance objective. No impact on NAVPS of fund. |
| N/A (no daily reset) | Non-recourse leveraging. Most an investor can lose is initial capital investment. |
| Usually no drawdown or return of capital distributions to investors —only tax implications are usually capital gains |
Usually no drawdown or return of capital distributions to investors —only tax implications are usually capital gains |
Investment rationale
Purvis says advisors need to have a clear investment objective for the client before recommending LETFs.
“If you want to eliminate the market risk of a portfolio, you can take an inverse position on the market and use the ETF as a hedge,” he says. “An inverse leveraged ETF allows you to use half the capital to get twice the hedging position, making it an effective hedging tool for many portfolios.”
And, since most investors have a buy-and-hold philosophy, adding LETFs to a portfolio means the advisor will have to do a lot of explaining. McMahon says investors need to refrain from holding LETFs over multiple days, and need to fully understand the daily reset and balancing that goes on.
“For the right investor, leveraged ETFs can be the Tabasco to add spice to the portfolio. The problem is, not everyone can take the heat,” says Lambert.
Lisa MacColl is an Ontario-based financial writer.
