Top gear?

Leveraged and inverse ETFs have been causing a regulatory fuss in the US. Martin Steward unpicks the issues, and asks if these products are of any relevance to pension fund investors

Leveraged and short (or inverse) ETFs, designed to provide returns that are a multiple or the opposite of a reference index, are not new. But this summer a background hum of criticism burst into the mainstream, and into the corridors of power. In the US in July, the secretary of state in Massachusetts started scrutinising Rydex Investments, Direxion and ProShares, three leading leveraged and short ETF providers; in August the SEC warned that investors “could suffer significant losses even if the long-term performance of the index showed a gain”; and brokerage firms including Morgan Stanley, Wells Fargo Advisors and UBS stopped selling the products. Critics railed that investors were being duped with non-transparent products that “don’t deliver what they advertise”.

What they advertise poses two questions: do they achieve the multiple (often 2x) or the opposite of the daily percentage change in their reference indices; and how disappointed will you be if you are expecting them to deliver you two-times the reference index over a longer period?

“There has been some significant slippage versus the underlying indices in the US, particularly on the overseas benchmarks, because they were closing the fund each day on a best-efforts basis,” says Scott Thomson, head of UK distribution with ETF Securities. His firm has raised $200m in the last few months on its ETF Exchange platform, which so far includes leveraged and short versions of the DJ Euro STOXX 50, FTSE100, DAX and CAC40 indices. “They are not guaranteeing delivery of the final value of the index.”

If an investor buys $1,000 worth of a 2x leveraged ETF whose underlying index rises by 5%, at the end of the day the investors’ cash return is $50, but his cash-plus-leverage return is $100. The ETF provider has to re-hedge exposure by going to market for $50 worth of stock, and because he has to do so before the close, he takes the risk that the market decides to pop up another few basis points after he is done for the day. More accurately, he passes that risk on to the end investor.

“In the US the fund bears that re-hedging risk, as opposed to the swap counterparty under our model,” says Mark Weeks, chief executive officer at ETF Exchange (Europe). He is describing the standard European total-return swap structure: the counterparty still has to do all the tricky end-of-day re-hedging, but he cannot pass that risk back to the ETF. “We get the swap provider to guarantee the return,” says Thomson. “If you’re providing a swap, then you really ought to be providing a swap.”

Tracking error for daily returns is not an issue for swaps-based ETFs, agrees Dan Draper, global head of synthetic ETF pioneer Lyxor, which offers short and leveraged CAC40 and DAX products. “But is there tracking error in terms of someone’s perception of what the product ought to be doing? That’s a different question.”

And that question is one of simple compounding. If a $1,000 investment goes up by 5% in one day, the investor has $1,050. If it goes up another 5% the next day, the investor has $1,102.50, a total return of 10.25%. If the same $1,000 went up 10% one day and 10% the next, he would have $1,210, a return, not of 20.5%, but of 21%. Reduce $1,000 by 5% one day and 5% the next and you end up with $902.50, a loss of 9.75%; reduce it by 10% one day and 10% the next and you end up with $810 - a loss, not of 19.5%, but of 19%. So even after just two days, you don’t get 2x the percentage price change of the index. Still, your gains are higher and your returns lower, right? But if $1,000 goes up 5% one day and down 5% the next, you lose $2.50 or 0.25%; if it goes up 10% and then down 10%, you lose $10 or 1% - a whopping 4x the index loss over those two days.

The first obvious conclusion from all this is that there is no necessary relationship between the compounded returns of daily price changes and multiples of those daily price changes (firms like Direxion in the US and db x-trackers in Europe have decided to insert the word ‘Daily’ into the names of their short and leveraged products). Perhaps the biggest risk would be to assume that you could hedge a $1,000 S&P500 position with $500 in a 2x short S&P500 ETF over anything more than a few days. “If you’re a long-term buy-and-hold investor and you buy one of these daily-reset products expecting it to be a nine-month hedge, you’re going to be in big trouble,” warns Draper.

The second conclusion is that a leveraged product will fare best in trending, directional markets and worst in volatile, range-trading markets - because it is essentially a ‘buy-high, sell-low’ strategy. In fact, we might go further and say that products limited to 2x leverage really only work well on underlyings that exhibit very large percentage price movements. The danger otherwise is that when a move goes against you the ‘buy-high, sell-low’ mechanism erodes your asset base so much that the recovery can never be long or high enough to recoup the losses - as illustrated in figure 1, showing a simplified S&P500 example. The corollary to this is that an investor must be satisfied that risk is significantly asymmetric. In those circumstances the cost of carry (in terms of tracking error) during even an extended period of range trading could be bearable in exchange for full participation in the momentum trend, when it arrives. Commodities, arguably, meet these criteria more fully than developed market equity indices. Figure 2, showing a simplified oil example, starkly reveals that the potential rewards of the products come precisely from the ‘tracking error’ for which they have been criticised.

“We would always say that these are products for investors who have a strong directional view,” as Thomson says (ETF Securities made its name with commodity exchange-traded products, and it also provides leveraged and short versions of these). “Our onscreen volumes and what we hear from market makers suggests that investors use them very wisely - taking advantage of the market moves over multiple days, then coming out or going short.” Manooj Mistry, head of db x-trackers UK (which offers 1x short products and has filed applications in Luxembourg for leveraged products), agrees: “The trading volumes on exchange show higher turnover than for the regular products.”
But who is using them, beyond individual day-traders? The main institutional momentum traders - CTAs - are perfectly able to achieve much greater leverage than 2x or 3x using exchange-traded futures.

“These are strategies which are not entirely appropriate for investors who could do it themselves more cheaply without the counterparty risk,” says Chris Sutton, a senior investment consultant with Watson Wyatt.

True, but that still leaves candidates among the multi-manager, private banking and private wealth management communities. Even hedge funds might have reason to be tempted: “In markets where exchange-traded futures liquidity is not available, ETFs are potentially the fall-back to get leverage,” says Draper. “And with prime brokers severely limiting access to capital and pushing up margin requirements, traders who have hit their limits start looking at where they can get leverage built into products.” A futures-based momentum position will be less expensive than a leverage ETF, but the relationship will be fluid: the best tracking comes from the most liquid, front-month contracts; that means rolling positions every month for the duration of the trade, the cost of which is related to the shape of the futures curve.

But Nizam Hamid of iShares - which decided not to enter the leveraged and short market - cautions against seeing them as an operational shortcut. “There are institutions using them, but for the wrong reasons,” he says. “They know they should really be using swaps or futures but have tried to avoid the paperwork and due diligence, or setting up of ISDAs, by buying an ETF - and they’ve often not been happy with performance. Some on the trading side understand that they have their uses for trading intra-day, but for most there are better delta-one derivatives out there.”

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