4x ETF reveals the dark side of leverage decay

News that the SEC approved two 4× ETFs earlier this month – one long, one short – was met with both disbelief and derision.

The firm that filed for approval, ForceShares LLC, acknowledged in its preliminary prospectus that it’s “leanly staffed” and “has limited capital.” But that’s not stopping it from going where no ETF provider has gone before: quadruple leverage.

To achieve that, the ETFs will invest in large and small S&P 500 futures contracts, known as big contracts (250× the S&P 500) and e-minis (25×). Quadruple leverage being unprecedented, the funds will also invest about 5% of their assets in stop options, which are meant to stem the bleeding if the market loses more than 25%. In stop options, the long ETF will own puts on S&P 500 futures with strike prices that are 25% lower than the market; the short ETF will use calls 25% higher.

If the market drops more than 25%, the stop options will reduce losses, but the prospectus notes “it is possible that the stop options will not prevent a fund’s NAV from going to zero.” Zero net asset value, or NAV, means the ETF closes, and shareholders would lose his or her full investment.

Hans Albrecht, portfolio manager and options strategist at Horizons ETFs Management (Canada) Inc., is surprised the SEC approved the funds. “There was talk last year that the SEC was pondering rules that would cap leverage at 2×,” he says. He says that for the uninformed investor, owning the ETF can be “reckless.”

Read: Leveraged ETFs can help advisors without options licences

Daily rebalancing

As the preliminary prospectus warns, ForceShares ETFs seek “leveraged investment results for a single day only.” That’s a pertinent warning, since mathematics dictate that the longer an investor holds a leveraged ETF, the further it drifts from its objective of multiplying the underlying index. This effect, called leverage decay, is more pronounced in volatile markets – and further magnified for a 4× ETF.

The prospectus outlines an example of a 20-day trading period for an index with 12.54% annualized volatility (resulting in daily variations of +1.65% to -1.85%), but a cumulative return of 0%. Thanks to daily compounding and volatility, the 4x long fund cumulatively returns -0.71% during the 20 days, and the 4x short fund cumulatively returns -1.18% — even though the index finishes the period with 0% returns.

The prospectus also shows examples in a rising market where the short ETF could lose less than 400% and the long ETF could gain more than 400% due to leverage decay.

In very volatile markets, quadruple leverage can be quite pernicious. At Advisor.ca’s request, Albrecht illustrated leverage decay for a hypothetical 4× exchange-traded product that tracks Company ABC and rebalances daily. Over a volatile five-day period, the underlying ABC lost 1%, but the 4× ETP lost 16%.

Back in 2015, Morningstar’s Christopher Davis provided us with a real-life analysis showing the impact of volatility. Between July 1, 2015 and September 30, 2015, the S&P 500 was up 4.6%, while an S&P 500 2× bull ETF was down 14%, Davis found. “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 told us.

Read: Using the Greeks when trading: a primer

Who it’s for

Albrecht says leveraged ETFs are for “very targeted, disciplined use.” He suggests holding them for “a week at most,” and monitoring them daily.

They’re meant to hedge someone through a brief period (e.g., the recent French election). And, he says, leveraged ETFs provide an outsized hedge for smaller deployments of capital: “Instead of hedging with $100,000, you can hedge with $25,000 to give you similar exposure.” But once the event transpires, it’s time to get out, he suggests.

Read: Interested in leveraged strategies? Be cautious

If a client wants to hold a leveraged product, Albrecht agrees with Themis Trading LLC, which wrote about the 4× ETF in January: “Investors should at a minimum have to sign an agreement similar to the Options Disclosure agreement, [stating] that they fully understand the risks associated with leveraged ETF products.”

While the securities regulators do not require this oversight for leveraged ETFs, it’s “really not a bad idea for anyone who wants to trade something 2× or above,” says Albrecht.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.