Nothing to fear from ETFs

“I think the first lesson is to read the prospectus thoroughly,” Hallett says. “This I think is at the core of any of the criticisms that are out there. Had investors in these funds [read the prospectus] they would have a much better understanding around the expectations.”

In a study commissioned by Horizons BetaPro—the provider of such ETFs—Hallett says better education for both the retail investor and the financial advisor is probably a better course of action than slapping a “cigarette-style warning label” on the products.

He admits that he did not fully understand them at first either.

“My initial impression a few years back, when it was in mutual fund form, was that it would track over whatever holding period that you held the fund,” he says. “Once I looked into it, it was pretty clear that these were not as straightforward.”

The biggest criticism of leveraged ETFs has been that as the holding period lengthens, the returns can vary dramatically from the underlying index.

“While some have expressed frustration about the lack of tracking of holding period returns, it’s important to realize that tracking holding period returns risks losing more than 100% of the original capital. BetaPro’s structure, which is rebalanced daily, is needed to limit losses to 100% in a double ETF and provide investors with non-recourse exposure.”

Hallett points out that since the products are designed to track the daily movements of their given benchmarks, they are really not designed for longer holding periods.

“Buying and holding double ETFs should normally be done for short holding periods,” he says. “To assure accurate tracking of longer index holding period returns, an investor can leverage or short directly, or use double ETFs with a daily rebalancing strategy.”

He uses the example of the S&P/TSX Gold index, which, over a two-year period starting June 25, 2007, climbed 16.92%. At first blush, an investor might expect the S&P/TSX Global Gold Bull Plus ETF to have gained 33.84% and the S&P/TSX Global Gold Bear Plus ETF to have lost the same amount. In actual fact, the Bull ETF lost 41.47% while the Bear ETF lost 93.54% over the two-year period.

Despite the role of a longer holding period in widening, the performance gap, it ranks third in a list of contributing factors, according to Hallett. The most significant is the volatility of the underlying index, followed by the absolute value of returns.

So significant is volatility that in a zero volatility environment, where index gains or losses may be significant, but steady, the leveraged ETF actually outperforms the underlying index.

Depending on when the measurement is taken, equity markets will more typically have a volatility of between 13% and 20%, Hallett says. In a trending market, the volatility would be slightly lower.

“Zero volatility is unrealistic, but it’s there just to illustrate how volatility can affect these things,” he says.

If index drops by 60% in a year, but in a steady, zero-volatility fashion, a 200% direct correlation should result in a 120% loss. But Hallett calculated that the daily rebalancing structure would limit the losses of a 200%-exposure ETF to 84%. If the underlying index had gained 60%, again with zero volatility, the ETF would have returned 156%, rather than 120%.

Clearly, this kind of tracking error would not draw much criticism.

“Perhaps [the critics] missed this example. The S&P/TSX Capped Global Gold Index lost 56% from March 14, 2008 through October 22, 2008. Over the same period, HGU (Gold Bull Plus) lost 86% while HGD (Gold Bear Plus) gained 113%,” Hallett points out. “Where are the critics asking why HGU did not lose 11%? They are silent because they cherry-pick specific examples without delving into the exposure sought by double ETFs and the full implications of tracking double holding period returns.”

Index volatility had to reach nearly 40% for the ETF to under-deliver on its 200%- promise on the upside. On the downside, the ETFs actual return does not under-deliver on the 60% index loss, but will under-deliver on a loss of 35%, if the volatility reaches 60%.

Using the above scenario, the inverse 200%-ETF will underperform if the market drops 60%, but only if volatility reaches 60% as well. Underperformance appears again if the index gains 40%, with an index volatility of 60%—the ETF would lose 82.7%, instead of the expected 80%.

“Compounding leverage in a trending market enhances gains but reduces losses in comparison to simply doubling the holding period return or loss,” Hallett writes. “This is not unique to double ETFs; it is simply the math of compounding.”

In fact, if critics want something to seize on, it might be that Horizons BetaPro ETFs are exposed to some mild counterparty risk which could be mitigated. The structure of the ETF includes forward swap contracts with a single bank: National Bank. Should the bank fail—which is a very remote risk—there is a danger that the swap contracts would not be honoured.

Hallett suggests that BetaPro diversify its counterparty risk by entering into contracts with other large banks.

“On the plus side, concentration with one counterparty results in preferential pricing of the forward agreements,” he points out.

The options are riskier
The fact remains that for investors seeking leveraged, inverse exposure to a given benchmark, leveraged inverse ETFs may provide an inexpensive means to achieve that exposure.

Investors could use a margin account or a line of credit to leverage their investments, but these incur interest costs and run the risk of a margin call.

Inverse exposure can be had, if the investor is willing to accept the risks associated with shorting the index. But given that they could lose more than 100% of their initial investment, this is not for the faint of heart.

Short-selling in a margin account, using borrowed money combines all of those risks: margin calls, interest costs, and risking more than 100% of capital.

While leveraged ETFs do involve risks, the downside appears limited compared to this alternative.

“We prefer education to the cigarette-style warnings that critics have demanded of BetaPro double ETFs,” Hallett writes in the report. “Warnings, when read, can protect investors. Education, however, is empowering.”

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(09/09/09)