Point of no returns

Recent events have created sharp market declines and volatility, tempting investors to put their investment ideas to work through exotic products like leveraged exchange-traded funds (ETFs).

Many of these instruments are bundled with sophisticated names like 'ultrashort', 'double long' or 'inverse'. They benefit from the transparency associated with other ETFs, sound regulations and specialised index tracking supported by reputable sponsors.

They may initially look like traditional funds, offering a way to exploit a market direction using leverage. They imply double or even triple returns. Yet many investors are bewildered and disappointed when their leveraged ETF plays lose money even if they bet on the right direction of the underlying index.

Investors usually begin with sound intentions. For example, they are convinced that oil prices will rise 25 per cent this year so they look for a fund to reflect this. They find a leveraged ETF that claims to produce two or three times an oil index's return. But, if they read the fund's prospectus and marketing materials, it claims to produce daily leveraged returns of the index.

The key word is daily. A leveraged ETF is repositioned at the close of market, which means the fund provider will rebalance the assets to align the fund with the new shape of the market. This is done for logical reasons. The provider promised to provide leverage returns and it must take positions - adjusted daily - for it to pay out on this commitment. It cannot be caught out if the market moves against it. But, every time the oil index drops, the base for returns also falls. The leveraged basis for returns is greater on the downside than it is on the upside.

Let's take the example of a three-times leveraged long ETF linked to an oil index. Say the oil index falls 5 per cent in a single day. An initial HK$100 investment in the ETF would take that 5 per cent drop and multiple it times three, for a loss of 15 per cent (or HK$15).

The ETF is now worth HK$85. Say the oil index then goes up 5 per cent, back to its original level. The investor is entitled to a leveraged 15 per cent gain, but now the base for calculations is HK$85. Fifteen per cent times HK$85 is HK$12.75, leaving the fund with a value of HK$97.75, and the investor out of pocket by HK$2.25.

Basically, returns are greater on the downside than they are on the upside. In the above example, even though the index is flat for two days, the ETF's net return is negative. The more volatile the market is, the more exaggerated this tendency is towards negative returns. And, given the recent gyrations seen in global equities, that fact does not bode well for the returns of leveraged ETFs.

The table below illustrates the expected returns of six styles of leveraged ETF against a hypothetical benchmark. Using a 12-month investment period, the table below shows the potential losses of leveraging an index. Suppose you invest HK$2,000 in each of three types of leveraged ETFs with an annual management fee of 0.75 per cent. The first 'single long' and 'single short' are traditional, simple index ETFs that track an index without any leverage. Then there are two types of leveraged funds that also rebalance daily based on the day's index performance. The second and third types are specified as double and triple long and short (inverse), which return or lose two or three times the index result.

Notice that as this imaginary index moves from 1,000 up to 1,300 and back to 1,000 that none of the sample ETF values have returned to their original amount; all have made losses. Now investors in the long ETFs would be pleased at their returns after six months. Indeed, the 'double return long' fund returned 65 per cent. During this period the index didn't experience a single downtick - the market rose in a very ideal, smooth, progressive line.

But remember that increasing leverage from double to triple only amplifies the erratic and unpredictable outcomes. In reality, no market or index rises or falls smoothly over any period. Daily trading results are often choppy.

Even if an index meets your target result over the investment period, volatility will have introduced losses into your leveraged ETF valuation.

And because the daily rebalancing of assets means a leveraged ETF provider has to buy when the market is going up, and sell when the market is falling, the cost of maintaining these positions is high. Leveraged ETFs have substantially higher fees than straight ETFs.

Ironically, the investor would make a loss even if his view and target were correct. He simply cannot predict the exact path to his goals. Leveraged ETFs are very difficult to manage if you hold them beyond their daily rebalancing period.

There's nothing wrong with leveraged or inverse ETFs; actually, they do exactly what they are designed to do - track the daily changes in indices. But a fatal flaw exists in any long-term investment or portfolio hedge. The daily rebalancing of their constituent portfolios erodes the returns of even what appeared to be a smart trade.

There are ways of avoiding this daily rebalancing problem. Individual investors can lever up through use of a margin account, shorting an unleveraged ETF or using index options.

So how can leveraged ETFs be used successfully? They are great over one day. For example, if an investor is seeking to quickly liquidate a particularly large position he could buy leveraged ETFs (that represent a proxy to his position), sell his securities while using the ETFs as a hedge against volatility, then liquidate his ETFs at the close of market. By only holding the ETF for one trading day - the rebalancing period - the trader minimises his volatility risk and gets the full hedging benefits of the instrument.