In a previous column we discussed exchange traded funds and their utility in providing cost-effective exposure to broad market sectors and to some commodities like gold. However, a relatively new class of ETF has emerged that packs a potential wallop through the use of leverage to amplify the gain or loss in the underlying index. These leveraged ETFs are complex financial instruments that can sometimes behave in unexpected ways, and should generally be avoided by all but the most sophisticated investors.
One strain of leveraged ETF seeks to provide two or three times the daily price movement of the base index through the use of debt (in the form of equity swaps or futures). Another type seeks to capture two or three times the magnitude of the index change but in the opposite direction (known as "inverse" or "short" funds). Obviously, this approach exposes the investor to concentrated losses in the event of an adverse market movement. However, they are particularly unsuitable for buy-and-hold investors due to the nature of their construction.
Leveraged ETFs are subject to daily rebalancing to maintain a constant leverage ratio. At the end of each day, the holdings are rebalanced to begin trading the following day at exactly two or three times leverage. This implies that gains or losses are compounded daily, creating the potential for a significant tracking error over time. Unsuspecting holders can find that losses are magnified well in excess of the leverage ratio, especially during periods characterized by large swings in the underlying index.
One particularly disconcerting example involved the Russell 1000 Financial Services index, which gained 8 percent between Dec. 1, 2008 and April 30, 2009. The fund seeking to produce three times the index return actually fell 53 percent over the same period, while the fund geared to generate three times the inverse of the index plummeted 90 percent.
FINRA, the primary regulator for securities brokers in the U.S., has issued guidance on the use of leveraged ETFs. While they can be usefully employed in targeted strategies, they should not be held by retail investors for more than a day, especially in volatile markets. In response, some firms have prohibited the sales of these instruments.
While conventional index ETFs are effective and appropriate for individual investors, the high-octane leveraged varieties could prove hazardous to the health of your portfolio.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Chris Hopkins is vice president, investments, at Barnett & Co. Inc. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com.