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Mark Yamada is CEO of PUR Investing, a Toronto-based portfolio manager that uses exchange-traded funds.

Canadian investors may be the most mistreated on the planet, so they should not be surprised if leveraged and inverse exchange-traded funds were deliberately designed to dupe and mislead them. Such is the rhetoric of investor protection groups.

The highest volatility in 80 years distorted returns for leveraged ETFs, or 2xETFs, that aim to double the daily return of an underlying index for bull versions or double the inverse for bear versions.

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These ETFs have attracted much criticism; their use has been curtailed by some and banned by others. Self-regulating organizations, FINRA (U.S.) and IIROC (Canada) stated: "Inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets."

"Unsuitable" means brokers can't use them for clients beyond a single trading day. But would investors be positively or negatively impacted by holding these ETFs for periods longer than one day in different markets with different volatilities?

Mind-Blowing Results

The gripe is that 2xETFs did not do what some investors expected last year. This table shows how 2xETFs fared against the S&P/TSX Capped Energy Index for the year ended September 30, 2009. Making the right call (falling index) cost almost as much as making the wrong call, and both cost a bundle.

Year ending September 30, 2009

S&P/TSX Capped Energy Index

-8.3 per cent

HBP Capped Energy Bull Plus ETF

-41.8 per cent

HBP Capped Energy Bear Plus ETF

-66.4 per cent

To be clear, these ETFs delivered pretty much what they promised, two times the daily return of the underlying index. Translating daily returns to compounded returns during periods of high volatility involves volatility drag; higher volatility means higher drag.

Volatility drag is the impact that wide price fluctuations have on the difference between simple and compounded returns. If an index or security drops 10 per cent, it has only to gain 11.11 per cent to get back to even. If it falls 50 per cent in price, it has to double to get back to even. The difference is the result of volatility drag.

Professionals understand this, but retail investors and many of their investment advisers (formerly called stockbrokers) may not.

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Crying "foul", the Canadian Foundation for the Advancement of Investor Rights (FAIR), an investment-industry-funded non-profit organization representing the interests of Canadian investors in securities regulations, called for better disclosure in prospectuses and "point-of-sale" materials. The irony is that most investors don't read prospectuses and the characteristics of leveraged ETFs are already disclosed.

Volatility Gone Wild

Off-the-scale volatility in 2008-09, created drag that destroyed these ETFs' returns. We can thank FAIR, FINRA and IIROC for bringing attention to the issue, but there is another side to this story.

Over a different period, the HBP Financial Bull Plus ETF rose 86.9 per cent (more than twice the index) and the HBP Financial Bear Plus fell 69.3 per cent (less than twice the index). These are very different results. Upside gains were enhanced and losses mitigated. Investors win!

YTD September 30, 2009

S&P TSX Capped Financial Index

41.4 per cent

Horizon Beta Pro Capped Financial Bull Plus ETF

86.9 per cent

Horizon Beta Pro Capped Financial Bear Plus ETF

-69.3 per cent

Over different periods, and for holdings in excess of one day, 2xETFs can offer attractive results. Many critics assume the same level of volatility drag exists all the time and is always negative. This is simply not true.

Hypothetical one-year S&P 500 volatility "drag", calculated daily from 1950 to September 2009, is shown below. The number of "positive" drag days about equalled "negative" days, but there were far more positive spikes benefiting investors (+10 per cent) than negative spikes (-10 per cent). Holding periods are one year.

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So why do FINRA, IIROC and FAIR want to limit activity to day trades? Could it be that:

- capital markets were so devastated that somebody had to take the blame?

- these organizations don't really understand the products and think they are evil?

- they understand the products but don't trust stockbrokers to use them properly?

The last reason would be understandable, either of the first two, disappointing. Leveraged ETFs allow individual investors to gain more efficient risk exposure while deploying less capital. Sophisticated institutions have been doing this for years but individuals, dealing through advisors, are constrained.

When Canadian investors are subjected to oligopoly bank pricing and the highest mutual fund fees in the world, should watchdogs focus on retail investors with $1-billion in assets (non-institutional, non-adviser-based) or on mutual fund holders with $583-billion, neither of whom read prospectuses?

Volatility drag would have favoured leveraged ETF investors by a significant margin from 1950 to date. A failure to consider this will inadvertently penalize investors.

Let's be fair, responsible criticism of any product should balance problems, like 2008-2009, with possible outcomes in different markets and time periods. Regrettably, this was not done for leveraged ETFs. To benefit from 2xETFs, Canadian investors must now educate themselves, something we and FAIR both support. Maybe this is a good outcome from a perhaps unfair, but certainly unbalanced attack.

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