ETF Analyst: “Leveraged ETFs are Toxic.”

The Exchange Traded Fund (ETF) industry is fast becoming the darling of the asset management sector with investors piling in with abandon - $270bn in 2008 alone. However, many of these investors are not fully aware of the way these products are evolving from passive vehicles providing exposure to a market, into sophisticated instruments that require advice from an expert. In this article we look at the example of how misuse of leveraged ETFs can destroy value.

Leveraged ETFs are pitched as incredible tools that accelerate wealth creation by returning double or triple the returns of an underlying index. And if you don’t want to bet on a rising market there are Inverse ETFs, which claim to return two or three times the inverse of an index: the S&P falls by 5%, but you make 15% - nice!

Individual investors with a sense of conviction dive into these products betting on all sorts of movements, from dollar depreciation, to an uptick in gold, to changes in the price of commodities like wheat, zinc and tin. The products are created quickly to capture the themes of the day, and have exciting names like “Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF” and “Energy Bull 3X - Triple-Leveraged ETF.”

It makes an individual investor feel like a real pro when he can trade in and out of the market, making leveraged bets like the hedge fund managers he reads about. After all, everyone knows the dollar is heading for a fall so why not triple the returns and make up some of that cash that was lost in the last stock market crash?

Unfortunately this is just another Wall Street product that is being sold to Main Street suckers who don’t understand how ETFs work…

Over $30 billion has been plowed into leveraged and inverse funds over the last two years, but what most individual investors don’t know is that you shouldn’t hold these funds for more than a day – that’s right a single day! To be sure, this is not something that Benjamin Graham would be recommending.

The fact that is missed by most people is that by holding most of these ETFs for longer that the typical compounding period of a single day you will lose money. Let’s take for example the Horizons BetaPro Bull ETF – it lost 46.4% over the first three months of 2009, yet the gold index it was supposed to magnify returns of increased by 1%. Another example is the energy Bear ETF which lost 25.4% over the same period, when the index of which it is supposed to deliver the inverse of dropped 39.4%. You don't need to be an ETF analyst to see the dangers.

Funnily enough these products are performing exactly as they should – the ETFs exposure to the index is reset on a daily basis. The problem is that many investors don’t realize this is the case, and end up with returns that don’t correlate to what they thought they were supposed to get.

Is this situation the fault of the funds? Absolutely not. It is the fault of individuals self-managing their funds into financial Armageddon with no understanding of just what they are investing in. Investors need to be aware that certain types of ETFs are becoming more and more like structured products that make use of derivatives to get the returns. Levered bull and bear funds are financial trading products, not investments to hold.

The information contained in this article is for information purposes only, and it does not hold itself out as providing any legal, financial or other advice. But what it does seek to illustrate is just how important it can be to get high quality advice when it comes to managing investments.