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Setting the global standard for investment professionals Leveraged Exchange-Traded Funds: The Chain Saw in a Tree? A major manufacturer of chain saws includes a warning (paraphrased) in its owner’s manual: • This product is not designed for consumer use in a tree. • Only trained professionals should use this product in a tree. Leveraged ETFs (exchange-traded funds), perhaps the arboreal chain saws of the financial world, continue to proliferate. In the May/June 2009 issue of CFA Magazine, Rodney Sullivan, CFA, reviewed Morningstar’s data and counted 145 ETFs that combined have attracted $27 billion in assets. The size of this market seg- ment has led to concerns that leveraged ETFs might be the next investment product to generate substantial investor losses. To begin, let’s define a conventional ETF. ETFs INVESTMENT An ETF is an investment vehicle that pools assets in order to meet INSIGHT certain identified objectives, most often matching the return of Arbitrage: Arbitrage is the act of making profitable a particular index (e.g., S&P 500 Index; Russell 2000 Index; an trades based on price differences between the same index representing a specific equity sector, gold, oil). Rather than or similar securities in two or more markets. For purchase all the components of the target index individually, the example, the share price of IBM on the New York investor purchases an ETF security representing an interest in a Stock Exchange and the futures price of contracts pool of assets replicating the index. Unlike a conventional (open- for IBM shares on the Chicago Mercantile Exchange end) mutual fund, an ETF trades throughout the day, with market should be linked economically. Arbitragers might arbitrage providing some level of confidence that the value of seek to profit by buying (selling) IBM in New York the ETF will track the performance of the relevant index. If prices and selling (buying) forward in Chicago. Any earnings diverge, investors could arbitrage the price disparity—for example, after consideration of interest and dividends would by purchasing the stocks in the S&P 500 and converting them into constitute arbitrage profit (which should be fleeting S&P 500 ETFs, thereby realigning the price of the stocks and the in such developed markets). S&P 500 ETF representing the stocks. Why bother investing in an ETF? ETF investors can participate in index returns without needing to purchase all the shares (or participating in derivative contracts), appropriately weighted, that the index includes. The rationale parallels the reasoning behind investing in a closed-end fund. ETFs are similar to closed-end funds in that shares are bought and sold on exchanges, as opposed to open-end mutual funds, which redeem shares or offer new shares to meet demand. Areas of differences between ETFs and mutual funds can include INVESTMENT • brokerage fees, INSIGHT • annual expense ratios, • continuous versus daily pricing, and Open-End Mutual Fund: An open-end mutual • tax efficiency. fund is an investment vehicle in which the mutual fund company redeems shares or offers new shares Investors should consult their investment adviser for assistance in to meet investor demand. The mutual fund share deciding which approach makes sense for them. price is calculated as the combined market value of the fund’s individual assets divided by the number Leveraged ETFs of shares, resulting in net asset value per share A leveraged ETF uses borrowed money (or derivatives) to amplify (commonly called NAV). investment returns. Leverage can work for you or against you Closed-End Fund: A closed-end fund is an depending on the performance of your investment relative to the investment company that issues a fixed number cost of the debt used to acquire the asset. For example, if you buy of shares that are normally not redeemable until a stock that is worth $50 today and in a year it is worth $75, you the fund liquidates. Typically, an investor acquires have experienced a one-year return of 50 percent. If, in contrast, shares on a secondary market from another investor you borrow 50 percent of the value of the stock, you can buy two or a market maker, as opposed to an open-end shares today for $100 ($50 of your money, $50 from your lender), mutual fund, where the fund company redeems or and in one year, you will have $150 in stock with debt outstanding offers new shares to meet demand. Shares trade at of $50 (assuming a generous banker who charges 0 percent interest), a premium or discount to NAV. for a return of 100 percent ($50 investment, $50 profit). A variation on the leveraged ETF theme is the inverse ETF, which tracks the opposite of the return on a particular index. For example, if the S&P 500 increases 5 percent, an inverse ETF might decrease in value by 5 percent. These instruments allow investors to bet that the market will decline without having to sell securities short. Rather, the ETF sells the securities short or creates an equivalent position with derivatives. Some inverse ETFs may also amplify the risk by two or three times. A leveraged ETF uses this rationale to offer investors a chance to benefit disproportionately from market changes, whether positive or negative (investors capture value from negative index returns by purchasing inverse ETFs). The problems with this approach fall into three broad categories: 1. harmful effects of return volatility, 2. difficulties with execution, and 3. issues of investment philosophy. Return volatility Just as compounding positive returns can result in average returns that exceed the return that occurs in many or all individual years, the variability of returns that leveraged ETFs amplify will result in returns that will often be worse than the two-times (2×) or three-times (3×) result indicated by the fund’s name and strategy. Let’s take an S&P 500 fund as an example. An ETF might offer investors a return intended to track the S&P 500, whereas a leveraged ETF might offer the S&P 500 return times two or three. If the S&P 500 experiences a return of –10 percent and then +20 percent, an investment of $100 grows to $108. An investor in an ETF might expect a 2× or 3× fund to yield two or three times the 8 percent of the unleveraged ETF. Such is not the case, as shown in the following table. Index/ETF Initial Investment Move 1 Move 2 Total Return S&P 500 –10% +20% $100 $90 $108 +8% S&P 500 × 2 –20% +40% $100 $80 $112 +12% S&P 500 × 3 –30% +60% $100 $70 $112 +12% Notice that, despite delivering two or three times the risk, the leveraged ETFs did not deliver two or three times the return. The differences from the stated target increase with volatility and over time because of the math associated with negative compound returns. Imagine gaining and then losing 100 percent to get an understanding of the problems associated with the math of large, variable returns. Actual investor experiences with leveraged ETFs bear this out. Execution Managers of ETFs often rely on derivatives to execute their strategies. The prices of derivative positions can vary from the underlying asset prices because of a range of factors. For a more complete understanding, consider discussing the following with your investment adviser: • market pricing, • tracking error, • counterparty risk, and • term structure mismatches. In addition, unlike the kind banker in the earlier example, lenders to ETF managers charge interest, which is a drag on performance. Buying high, selling low? Finally, a key issue for investors in leveraged ETFs is the promise of a fixed multiplier of return: Managers commit to maintaining a constant leverage ratio. As asset prices fall, these managers reduce their positions in the underlying assets to maintain a constant leverage ratio. Imagine you promised your lender that you would maintain a certain maxi- mum ratio of debt to your net worth. If your net worth fell, you would have to sell assets (a margin call). In effect, you are obliged to sell assets as asset prices are falling. Although this may save you from disaster in an extreme situation, you may, in most situations, prefer the opposite: to buy assets when prices are falling. The bottom line Leveraged ETFs are complex and risky financial instruments that are not for everyone and very likely represent a poor fit for most individual investors. To revert to the example that leads this article, if a tree limb threatens to fall on your home or pool, consider hiring a professional to do the job—or the limb you cut may be your own. For more information, please consult www.cfainstitute.org/adviser The information contained in this piece is not intended to and does not provide legal, tax, or investment advice. It is provided for informational and educational use only. Please consult a qualified professional for consideration of your specific situation.
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