Leveraged Exchange Traded Funds

Back in August I wrote about some of the pros and cons of using Exchange Traded funds (ETFs) and investment trusts as an alternative to conventional mutual funds.

One area of ETF investing that is often commented on by investors is the use of Leveraged ETFs.  It’s not really surprising when you see returns of 80% over a 6 month period (leveraged Soybeans) and more recently Leveraged Silver has gone up nearly 40% in 4 weeks – it’s easy to see why they are fast becoming one of the most popular types of ETF. However they don’t achieve this without some controversy and before you make the decision to use them there are some basics to understand.

An ETF tracks indices or commodities in an attempt to emulate rather than improve on their underlying performance.  Leveraged Exchange Traded Funds or ‘Leveraged ETFs’ attempt to take this a step further by trying to outperform the index or commodity and not by a small margin.

Some of the most popular funds will be looking to produce 2 or 3 times the return of the correlating asset.

Like an ETF they will include the same securities as the underlying index however they will also use derivatives of those securities allowing them greater freedom to take advantage of market conditions.  These derivatives can include, but are not limited to options, futures, forward contracts and swaps. The mix of derivatives and underlying assets is done in such a way that you should see a multiple of the return on the index.

In theory a 2x Leveraged ETF should create a 2% return if the index rises by 1% but there are other factors influencing the return.

The first of these, tracking error, is common to both ETF and Leveraged ETFs and is the difference between the return of the index and the performance of the ETF.  This can be affected by how illiquid a particular market may be or the level of charges being made by the provider.

If the ETF is only holding a selection of assets rather than a full replication of the index then this may reduce some of the dealing costs but this can add a level of active management that eventually produces a much larger tracking error.

Tracking errors of 10% are not uncommon which can of course get magnified in a leveraged fund.

One of the most common misconceptions of Leveraged ETFs is that the leveraged returns are on a yearly basis.  They are in fact designed to create a multiple return on a daily basis.  In highly volatile market this could create quite a difference (both positive and negative) when comparing the 12 month performance against the underlying securities.

By their very nature the return from ETFs can be very volatile and this will be magnified by leveraged funds. Investors sometimes hear ‘multiple returns’ and automatically think ‘multiple profits’ however they can just as easily create ‘multiple losses’ as well.

A good example of this is Leveraged Tin which has produced a very desirable return of 21% in the past 4 weeks but over 12 and 26 weeks has struggled with -2% and -31% respectively.  Based upon your timing in and out of that fund your eventual return could have been considerably higher or lower than these figures.

Both ETF and Leveraged ETFs offer some real opportunities providing you are sensible about your overall exposure but if you are going to dip your toes into that market then be prepared for a bumpy ride if you don’t intend keeping a very close eye on your portfolio.

For our analysis of the ETF, Investment Trust and mutual fund market we have found the information in a regular publication called saltydog investor invaluable and definitely worth a look if you are considering making any investments.  Check their website at www.saltydoginvestor.com