The Great ETF Swindle

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

"Don’t invest in something you don’t understand".

A motto I usually stand by, as a result I will not touch ETFs or Leveraged ETFs.

Exchange traded funds, or ETFs, originated in the late 1980s and popularity grew quickly as they provided a cheaper way for investors to invest in a basket of stocks, without the high management charges of mutual funds or hedge funds. They also allow smaller investors to access larger markets which usually require large amounts of capital or specialist skills. The United States Oil Fund (NYSEMKT: USO) and the well-known SPDR Gold Shares  are good examples of funds that provide access in usually inaccessible markets.

The Benefits of ETFs are numerous:

  • Diversification - allows investors to hold a basket of stocks or buy into markets that are not usually accessible. Such as the iShares Dow Jones US Oil Equipment (NYSEMKT: IEZ), that invests in companies in the oil equipment industry, or SPDR S&P Oil & Gas Exploration & Production (NYSEMKT: XOP) which is focused on energy and production companies.
  • Lower management fees.
  • ETFs trade like a stock - resulting in intra-day pricing allowing for complete price transparency. Meaning it is less likely an ETF will trade at a discount or premium to the net asset value.
  • Dividend reinvestment- dividends are held within the ETF and reinvested.
  • Tax efficiency.

On the other hand there are also disadvantages to ETF investing.

  • ETFs trade like a stock - both positive and negative, constant pricing could distort longer term investment horizons.
  • Large Spread - could be a possibility for less liquid assets in developing markets.
  • Costs could be higher.
  • Dividend Yields - income could be non-existent or smaller than owning the individual assets. Such as the iShares High Dividend Equity Fund (NYSEMKT: HDV), which yields 3.4% but has an expenses ratio of 0.4%, reducing the yield to 3%, lower than the average of its top 5 holdings.
  • Leveraged Emfs - a major negative.

Leverage

Leveraged products such as the 2x ProShares Ultra S&P500 (NYSEMKT: SSO) can be incredibly good at boosting shareholder returns over the short term, but adding leverage to an ETF can be very dangerous; Leveraged ETFs can be unpredictable instruments for the individual investor.

To understand the risks of a leveraged ETF you need to understand how they work.

Life Cycle of a 2x leveraged ETF

  1. Like a normal ETF, the leveraged ETF starts off with a basket of cash, in this example $1000
  2. The leveraged ETF then buys exposure to the underlying index using derivatives (futures, options and swaps). As the ETF is leveraged 2x the value of these derivatives will total $2000, (2 x the starting capital).
  3. Typically the ETF will keep the majority of its assets in cash and short term securities. To cover losses.

-Now the risky part-

The Leveraged ETF must now maintain exposure of twice its asset base.

  • On the first day of trading the underlying index rises 3%. This produces a $30 profit for the ETF.
  • The ETF now has assets of $1030.
  • To maintain 2x leverage the firm must buy more derivative contracts, to maintain its exposure to the index. In this case the ETF must increase its exposure to $2060
  • This process is called rebalancing and the leveraged ETF must undertake it every day to keep a constant leverage ratio.
  • Without re-balancing the ETFs leverage ratio would change every day and returns would become unpredictable.

Leveraged ETFs are designed to mirror a daily gain or loss on the underlying index. They do this well however investing for longer than the designed daily period becomes highly erratic. The constant daily re-balancing will cause returns to become unpredictable.

<img src="/media/images/user_14485/leveraged-etf_large.jpg" />

These tables explain everything. The non-leveraged return is 0%, the asset is the same value at the end of the week as it was at the beginning of the week. However all the other leveraged ETFs have provided negative returns. This is down to the constant re-balancing of the ETFs. The constant re-balancing causes the assets base to constantly change, constantly changing returns.

In a constant Bull market long leveraged ETFs will maintain their returns, the same as leverage short ETFs in a constant Bear market. The problems start to arise with volatility, the constant up and down movements of the volatile market constantly change the ETFs asset based resulting in unpredictable returns for an investor who has an investment horizon longer than one day.

Leveraged ETFs are great, and do their job amazingly well, but their job is only to replicate price movements over one day - any longer and they are useless.


RupertHargreav has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus