After three months of extreme uncertainty, the future is becoming clearer – at least a little – for investors in leveraged oil ETFs flattened in April’s crude-oil cratering. And while experts don’t believe a repeat pummelling is possible, investors are being warned about buying into these complex products.
On April 20, West Texas Intermediate (WTI) crude dove into negative territory thanks to worldwide COVID-19 lockdowns that wiped out tens of millions of barrels per day of oil demand, filling up storage capacity on land and at sea. Facing a daunting oversupply, holders of front-month contracts for May crude deliveries scrambled to offload them, resulting in a historically low settlement at minus US$37.63 a barrel.
That came after weeks during which investors, spurred by low prices, began buying into oil ETFs such as United States Oil Fund (USO-A) (the world’s largest by assets – valued about US$4.3-billion today), as well as leveraged oil ETFs.
Unlike standard oil ETFs, which simply track crude futures contracts, leveraged ETFs use complex derivative contracts to amplify returns (or losses, in the case of inverse funds). When oil tanked on April 20, most of these funds had already rolled their exposure from May contracts to June – but the following day, June futures plummeted 43 per cent to a two-decade low of US$11.57 a barrel.
“Our ETF was exposed to the June futures contract,” says Steve Hawkins, president and CEO of Horizons ETF Management (Canada) Inc., the only provider of leveraged oil ETFs in Canada. His company managed two leveraged oil ETFs, the Crude Oil 2X Daily Bull (HOU-T) and Crude Oil -2x Daily Bear (HOD-T).
“If you’re in a 2X product, it doesn’t matter the underlying asset,” Mr. Hawkins says.” If oil goes down 40 per cent, you’ll lose 80 per cent. And that’s what happened to HOU.”
Warning that offer prices in the coming weeks were “not expected to be reflective of the underlying net asset values,” Horizons took the unprecedented step of suspending subscriptions in the funds, which were suddenly at risk of liquidation.
It also warned investors not to buy shares on the secondary market, cautioning that low settlements in the coming months could force counterparties to terminate their derivative agreements, essentially wiping out the funds.
“I didn’t sleep much for four or five days,” Mr. Hawkins recalls. “We were monitoring overnight markets in crude every 30 minutes, talking to traders and banks, to figure out the next step of what we could do with the underlying exposure.”
The bloodletting in leveraged energy products wasn’t simply a result of WTI cratering. Throughout March, dozens of leveraged ETFs were closed or delisted due to pandemic-incited volatility. That didn’t stop some investors, attracted by low prices, from piling into the funds in anticipation of a recovery. That, say experts, is due to a fundamental misunderstanding about how these funds work.
“People love trading these products, because if crude oil moves 5 or 10 per cent, you could see a 20-per-cent move in the ETF,” Mr. Hawkins says. “People love that possibility of quick returns…that’s what these products are built for. But they’re built for people who have a very sophisticated knowledge of what they’re doing.”
Leveraged ETFs are designed to track daily fluctuations, with their leverage reset every day, eroding returns over time. It’s a tricky concept that can be counterintuitive to investors who imagine it will merely track the price of oil.
They’re intended as instruments for savvy investors who hold them for short periods, from one day to a few, at most. Retail investors who don’t understand the instruments’ complexity were setting themselves up for a fall long before April’s crash.
“Suffice to say, oil is still extremely volatile,” says Daniel Straus, head of ETF research and strategy at National Bank Financial Inc. “The more volatile, the more that daily compounding will be a problem. Add the question of futures to that, and you’ve got even more decoupling between investor expectations and what might actually happen, with a very complicated numerical financial instrument.”
Most experts agree that a repeat of April’s extraordinary price plummet, while not impossible, is unlikely – but that doesn’t mean leveraged ETFs are a safe bet.
“The fact that the front month went negative filled people with questions,” Mr. Straus says. “‘What happens to my ETF if I’d had slightly different timing?' It’s possible that a deeper, longer lockdown could drive an ETF into negative territory. Then would the unit holders be on the hook for debt payments? A whole host of unknown questions erupted, and the answers are still unknown.”
On July 3, Horizons announced shareholder approval of changes to its two leveraged oil ETFs, the only two offered by a Canadian fund manager. Most notably, the renamed BetaPro Crude Oil Leveraged Daily Bull ETF (HOU-T) and the BetaPro Crude Oil Inverse Leveraged Daily Bear ETF (HOD-T) are now indexed to a proprietary Horizons index. Instead of a fixed 2X leverage ratio, Horizons fund managers will be able to tweak leverage based on market conditions.
“We can essentially change the contract exposure,” Mr. Hawkins says, “and do what we want more actively, without going to an index provider, and without deviating from the investment objectives.”
That may soften future risk, but it could also put a damper on why people get into these funds in the first place.
“Investors may not find it as attractive because of that safety stopgap,” says Ian Tam, director of investment research with Morningstar Canada. “But from our perspective, that’s a good thing. You don’t want people losing their wallet over too much leverage.”
With volatility likely to be a permanent feature of oil markets, investors may end up being glad for such modest security.
“More and more, [oil is] a geopolitical football,” Mr. Straus says. “You have well-capitalized government actors that can turn on and off spigots and move dials to wage economic warfare for market share. Add to that the pandemic. Add to that the global climate crisis, and the movement to wean the world of oil. The long-term prospects are really called into question.”
The belief shouldn’t turn off investors looking to play with these ETFs as they’re intended: as day-trading instruments for knowledgeable investors with the stomach – and resources – to weather the risk.
“These are high-risk products,” Mr. Hawkins says. “They’re not for the faint of heart.”