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.