The rising star among Canadian exchange-traded funds is an unusual animal - it allows investors to profit handsomely from a bear market for stocks.
The Horizons BetaPro S&P/TSX 60 Bear Plus ETF was introduced Jan. 9 and has already become the second most heavily traded of the 47 or so ETFs listed on the Toronto Stock Exchange. After more than four years of strong market returns, it's clear that many investors are worried about a serious pullback.
HBP's Bear Plus ETF (HXD-TSX) is the most practical way for investors and advisers to prepare a portfolio for a down market, but it's a complex product. Deft handling is required, which is why this edition of the Portfolio Strategy is devoted to the ins and outs of this fund and several related products.
HBP currently has a lineup of TSX-listed exchange-traded funds offering bear and bull versions of not only the S&P/TSX 60 index of big blue chips, but also the S&P/TSX capped financials and energy indexes and the S&P/TSX global gold index. Each of these funds is leveraged, a financial term that basically means you get an extra bang for your buck, as well as extra risk.
Specifically, the HBP funds provide double, or 200-per-cent, exposure to whatever return the market delivers. The S&P/TSX 60 Bear Plus fund would gain 2 per cent if the underlying index fell 1 per cent in a day, and it would fall 2 per cent if the index gained 1 per cent.
This leveraged market exposure is a benefit in that it lets you commit only half as much money as you'd need in a conventional investment. If you wanted to bet on a market plunge with 5 per cent of a $100,000 portfolio, for example, you could do it with a $2,500 investment.
Leveraging also means there's a heightened potential to both make and lose money. In fact, you could theoretically lose all your invested money if you buy a bull or bear fund and the market charges in the opposite direction.
In an odd way, this vulnerability actually highlights one of the benefits of a leveraged bear ETF, which is that you can't lose more than your original investment. If you employed the usual strategy for profiting from a down market, short selling, you could end up in worse shape. When shorting, you borrow shares, sell them and then wait for a price decline to buy them back and return them to the lender. If the price of shorted stocks surges instead of falling, you'd have to pay additional funds beyond what the share cost in the first place.
Leveraged ETFs are constructed differently than traditional ETFs, and this accounts for their higher cost of ownership. Whereas traditional ETFs simply hold stocks in a particular index, leveraged funds use a complicated derivatives strategy to provide the 200-per-cent market exposure.
HBP's funds have a management expense ratio of 1.15 per cent, while conventional ETFs have MERs as low as 0.17 per cent. (That would be the iShares Cdn LargeCap 60 Index Fund, which is the most heavily traded Canadian ETF.)
Another wrinkle with leveraged ETFs is that their returns over a period of time will not equal two times the gain or loss of the underlying index. The mechanism that allows these products to provide 200-per-cent exposure to an index on any given trading day pretty much guarantees that longer-term returns will diverge somewhat from the index. For example, data from HBP show the S&P/TSX 60 index made 17.2 per cent last year, while the firm's bull ETF would have made 29.8 per cent according to back testing.
So much for how leveraged ETFs work. Now, let's look at some ideas for putting them to use in a portfolio. One rationale is to use them for hedging purposes, which means protecting your investments against a market decline by owning something that profits when stocks fall.
