01 Use the products to long or short an index, based on a prediction that the market will move in a certain direction in the short term. The CFA Institute guide outlines five main strategies for using leveraged ETFs. “But as an ingredient-a spice within a portfolio-for the knowledgeable investor, they can offer some opportunity.” Geared ETFs “are not by any stretch a total portfolio solution,” says Sapir. (More on the relative costs of these strategies later.) Both tactics avoid the multi-day return-drift pitfalls of geared ETFs.
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An advisor with an options license could buy a put option that lasts for six months, he suggests.Īnother strategy would be to short the client’s position, but that would require more capital than a put option. He recommends using options contracts instead. “They might be right and the markets may drop in the next three months, but, if they’re using a leveraged ETF, they’re not going to get the performance they thought.” “It’s a mismatch between the product and what they’re trying to achieve,” he says.
Leveraged ETFs are wrong for such clients. “They say, ‘I don’t know, I just think it’s going to crash,’ ” he says. If a client is predicting a crash, Vandermeer asks her when it’ll happen. These clients have high risk tolerances, and believe in their market opinions so strongly that they’re looking for ways to magnify the returns they expect. “They say, ‘I’ve got this opinion on copper.’ Or, ‘The market is going to crash,’ ” he says. They have self-directed accounts and came to him asking about leveraged strategies. Of Vandermeer’s 250 clients, two or three have leveraged ETFs. “You can put an ETF trade through for a small amount of money,” he notes. The suitability of leveraged ETFs for a client depends more on her motivation and less on how much she has to invest. “Can they handle the risk if that part of the portfolio doesn’t perform the way they thought?” “What is the client trying to do with the portfolio?” he asks. He also makes sure clients understand how the products behave by explaining compounded returns and plotting them on a graph to clarify how the ETF will perform. When he’s determining suitability, he reviews how a geared ETF would fit into the rest of the portfolio, how much of the portfolio it would make up and how it would interact with other investments. The ideal user, Vandermeer says, is “someone who is using this portfolio as a speculative investment.” He adds that inverse funds are useful for investors who want a different exposure to the markets, “rather than just being long-only and assuming that markets will rise.”
Further, a FINRA industry guide says leveraged ETFs are inappropriate for intermediate or long-term investors, and should only be used as part of sophisticated trading strategies. Who are leveraged ETFs for?īecause gains and losses rack up quickly, leveraged ETFs should rarely be held for longer than a day (see “ Regulator worries”). By comparison, a non-leveraged S&P/TSX 60 ETF could have a fee as low as eight basis points. At 130 to 150 basis points, leveraged funds cost more than non-leveraged ones, he adds. Of the roughly $80 billion invested in ETFs in Canada, as of October 6, about $99 million is in leveraged funds, says Christopher Davis, director of manager research at Morningstar Canada. Some funds also hold the underlying securities or commodities funds are rebalanced daily to ensure returns track the multiples promised. To achieve the multiplied returns, leveraged ETFs use futures, forward contracts, swaps and other derivatives. So if the S&P 500 goes down by 10%, a -2× S&P 500 bear ETF would go up by 20%, while a 2× bull ETF would be down 20%. Leveraged bull ETFs aim to multiply a benchmark’s return, while leveraged bears multiply the inverse of the benchmark’s return. Common benchmarks include indexes, commodities prices and sectors. Leveraged ETFs, also known as geared funds, aim to multiply a benchmark’s returns by two or three times. Others invested in them based on whether they thought the day’s market would rise or fall, write ETF industry experts Joanne Hill, Dave Nadig and Matt Hougan in a guide to the funds commissioned by the CFA Institute. When leveraged ETFs were first introduced, some institutional and sophisticated individual investors used them to hedge portfolios. The products “are for more seasoned and knowledgeable investors,” he says. Also sounding a note of caution is Michael Sapir, chairman of ProShares in Bethesda, Md.-the first company to sell leveraged ETFs, back in 2006.
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