Innovation in financial products is generally a good thing, reducing costs and increasing choices for investors. The development of Exchange Traded Funds or ETFs is certainly one of those beneficial developments, providing individuals with an inexpensive and tax-efficient alternative to traditional mutual funds. But innovators by their nature constantly seek to push the envelope. A relatively new variety of ETF seeks to multiply the magnitude of gains and losses through the use of leverage, presenting new and little-understood risks that render these rocket-fueled variants unsuitable for most long-term investors.
The popularity of exchange traded funds has exploded since their first iteration in 1993. That first fund, the SPDR ("Spider"), remains the largest entry in the field, replicating the return on the S&P 500. The vast majority of ETFs are passive, index-tracking vehicles with relatively low expenses making them well suited for buy-and-hold investors. There are hundreds of such funds today, garnering some $2.5 trillion in assets.
In 2008, regulators approved the introduction of a new variety of actively-managed ETF products employing more complex strategies. One such strategy was the use of leverage to multiply the gain or loss attendant to an underlying index. For example, an early entrant sought to produce, on a daily basis, twice the gain or loss of the S&P 500 index. That is, if the S&P gained 5 percent, the leveraged ETF would gain 10 percent on that day. Of course, the opposite applies as well, and a 5 percent loss in the index yields a 10 percent decline in the leveraged fund. So, first you have to guess correctly the direction of a daily market move (aside: no one can).
Christopher HopkinsShortly afterward came new offerings leveraged to three times the underlying index. And if you wished to bet against the S&P, you soon had the option to buy two- and three-times leveraged "short" funds that move opposite to the underlying index (meaning a loss in the S&P created a one day gain of double or triple in the ETF).
Those instruments were never intended to be held more than one or two days, and were targeted primarily at traders attempting to hedge other positions. Unfortunately, they soon became popular with individual investors who do not understand the hidden risks.
First is the cost. A basic S&P index ETF carries total annual expenses of around 0.03 percent, and many discount brokers now offer commission-free versions. Leveraged products carry high costs, often approaching 1 percent, eroding your return over time.
A less understood drawback for long-term investors is the reset of the leverage at the end of each trading day. This can generate a significant and unexpected loss even in a market that is relatively flat over time but varies day to day.
Consider this frequently cited example. Suppose an index fund tracking the S&P and an inverse (short) two-times leveraged ETF are each valued at $1,000. If the market rises by 10 percent, the plain fund ends at $1,100 while the souped-up index fund ends at $800 (down 20 percent).
Next day, suppose the market falls 9.1 percent, so that the plain fund returns to its original $1,000. The leveraged fund rises by 18.2 percent (2 times 9.1) to just $945 (ignoring expenses). Even if the market returns to even, you lose. This slippage can become quite large over time.
Last month, the SEC tentatively approved an abominable new four-times leveraged monster, but thankfully seems to be reconsidering its decision. These exotic instruments are strictly for the pros; individuals should stick to the low-cost, straight-up index versions for long-term investing success.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.