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Howard Atkinson is president of Toronto-based Horizons ETFs, a firm that offers leveraged and inverse exchange-traded funds. (Fred Lum/The Globe and Mail)
Howard Atkinson is president of Toronto-based Horizons ETFs, a firm that offers leveraged and inverse exchange-traded funds. (Fred Lum/The Globe and Mail)

Funds and ETFs

Beware when funds can’t pass the ‘napkin’ test Add to ...

Few investment vehicles are more polarizing than complex exchange-traded funds. But love them or hate them, experts tend to agree that retail investors need to tread carefully before using leveraged and inverse ETFs.

The U.S. investor Peter Lynch once said, “Never buy anything that you can’t illustrate on the back of a napkin,” says Eric Kirzner, a professor at the Rotman School of Management who holds the John H. Watson chair in value investing. “And you can’t with these.”

“These tools aren’t for everyone,” says Howard Atkinson, president of Toronto-based Horizons ETFs Inc., a firm that offers leveraged and inverse funds. “If you’re going to buy, hold and forget, don’t use these. … You need somewhat of a trader’s mentality for them.”

Most investors know that ETFs are securities that track major indices or economic sectors but are traded like stocks. Complex ETFs are riskier: Leveraged funds, for example, use derivatives and other means to magnify returns. If you buy a double-leveraged ETF and the underlying index goes up, your returns go up twice as much. The opposite is also true: If the underlying index goes down, your returns go down twice as much.

The returns work the same way with double-leveraged inverse ETFs, which are set up to perform the inverse of the index they are tracking, effectively shorting the market.

The problem for retail investors, says Russell Wild, a U.S. financial adviser and the author of Exchange-Traded Funds for Dummies, is that markets are volatile and “volatility eats returns” with these funds.

His example of how it works: Say an exchange such as the TSX/S&P goes up 10 per cent one day and then drops 10 per cent the next. If you own a $2,000 double-leveraged fund covering the exchange, on the first day you would make $400 and be left with $2,400. And because the ETFs are “reset” each day, on the second day you would lose $480 and end up with $1,920.

“The market is completely flat, back to where it started, and you’re down to $1,920,” Mr. Wild says. “So volatility is not a good thing.”

In fact, investors may have a tough time getting their heads around the concept of resetting. Leveraged ETFs are designed as short-term investments; when they are reset daily, it means they are designed to deliver amplified returns for the short time period of one day.

It’s crucial that investors comprehend that, says Tyler Mordy, president of Hahn Investment Stewards & Co. Inc. in Toronto. “I think the No. 1 thing that people don’t understand is that [leveraged ETFs] track daily performance,” he says. They are designed for the short term.

Mr. Mordy says complex funds can be an effective way to express a strong, short-term view on markets or commodities or a sector. But they aren’t meant for the value, buy-and-hold investor.

Mr. Atkinson says many investors shun complex ETFs because of misunderstandings about them. One is that they are for day traders, a perception he attributes to the fact that they are reset daily. The second is that you can lose more than the entire amount of your capital investment, which isn’t true.

Most transactions and trades of Horizons’ complex ETFs involve retail investors, he says, most of whom are anything but passive and use the funds as short-term investments.

To use them right, investors need to take a position on the market and then monitor their funds regularly.

Or they can use the funds to hedge. Mr. Atkinson cites as an example an investor whose portfolio, like that of many Canadians, holds energy stocks. The investor may want to keep those stocks for the long term, enjoying their dividend income and believing oil prices will rise in the long term. But if the investor also believes oil will fall in the short term, he or she “could hedge with either inverse oil or inverse energy ETFs to cushion the downside,” he says.

Mr. Wild, however, believes that leveraging of any kind is “just plain nuts” for the retail investor. Even bonds, a docile asset, can become a volatile investment, he says, and asset classes such as commodities become “incredibly volatile.”

That, and the fact that most complex funds have high fees, can really hurt returns, he says.

Then there’s the age-old debate about whether you can time the market. Retail investors like to think they can, but Mr. Wild and Prof. Kirzner argue that isn’t the case. “Professionals aren’t even capable of knowing which way an asset class is headed,” Mr. Wild says. “You can’t be sure. Nobody can be.”

Prof. Kirzner says there are better ways for investors who want higher risk to achieve their goals. “If you want to have a higher-risk portfolio, have a higher allocation to equities. If you want a very higher high-risk portfolio, then pick some volatile stocks.

“But leveraged ETFs aren’t the answer.”

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