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Leveraged and inverse ETFs: Handle with care

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Leveraged and inverse exchange-traded funds – also known as Bull x 2 or Bull x 3, or Bear x 2 or Bear x 3 ETFs – though available to retail investors, should be handled with care, experts caution.

Like most ETFs they track an index but they differ in the way they use leverage to try to double or triple the performance of the index, either directly or inversely by shorting it.

"If you have capital that you want to speculate with you can certainly get more bang for your buck," says Dan Deming, managing director at Chicago-based KKM Financial. He manages diversified ETF portfolios and offers leveraged and inverse funds to a growing number of retail investors with a taste for risk.

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"These ETFs have opened up a new category of vehicles that many retail investors didn't have access to five or 10 years ago," he says.

Leveraged funds were created – and are mainly intended – for big institutional traders who Mr. Deming says should understand derivatives and can devote their full attention to the markets.

"This is something that you have to be 100 per cent focused on. I would never recommend the use of these to someone who is not in tune with how they work and has the time to stay glued to the markets and their screen," says Mr. Deming.

His advice to retail investors wanting to take a walk on the wild side is to hope for the best but prepare for the worst. "Before you even think about how much money you might make, look at how much you might lose," he says.

Horizons ETF Management is the main provider of leveraged and inverse ETFs in Canada. National Bank is a counter party that actually does the leveraged management. Daniel Straus, head of ETF research and strategy at National Bank Financial, says most clients must first sign a formal agreement stating they are "sophisticated" enough to understand how they work.

"If it's easy to buy these types of products with one click, then it's incumbent on investors to educate themselves," says Mr. Straus.

He says the most common misconception about leveraged and inverse ETFs it that they are good long-term investments. "They are exchange listed and very easy to buy but in our view they are not buy-and-hold investments. They are trading tools and without proper understanding of the math behind them, it's very easy to make some costly mistakes," he says.

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Leveraged and inverse ETFs are considered "synthetic" – designed to use complicated derivatives like forwards and swaps to mimic an underlying index each trading day.

"They are promising at the beginning of the day that by the end of the day it will deliver twice or three times, or negative one time or negative two times the return of a reference index," he says. "We call this a daily rebalancing – a daily resetting – of leverage."

Comparing short-term returns, leveraged ETFs track their indexes and corresponding ETFs closely. But over longer periods of time they can derail.

One example is crude oil. Over the past year the Canadian dollar Horizons Crude Oil ETF gained in value by 36 per cent. It is a conventional ETF that tracks crude oil in Canadian dollars.

During the same time period, the BetaPro Crude Oil 2x Daily Bull Canadian dollar hedged ETF advanced only 28 per cent. It is intended to double the return of the conventional oil ETF.

The inverse version, BetaPro Crude Oil 2x Daily Bear ETF – which is intended to double the conventional oil ETF inversely – lost 64 per cent over the same period of time.

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Another example is the S&P 500. While the S&P 500 gained 13.5 per cent in Canadian dollars over the past year, the BetaPro S&P 500 2x Daily Bull Canadian dollar ETF advanced 47.3 per cent.

During the same time the inverse BetaPro S&P 500 2x Daily Bear ETF lost 38.6 per cent of its value.

Mr. Straus says the correlation between an index and leveraged and inverse ETFs becomes especially skewed in times of volatility. They tend to track more closely when the index trends, or moves in the same direction for extended periods.

"If the index goes up and down, and you're resetting your leverage at the end of the day – every day – it's very difficult to recoup if you've reset it after a losing day."

Investors pay a little more for leveraged and inverse ETFs. The annual fee, or management expense ratio (MER), is normally just over one per cent of the total assets invested.

Mr. Straus cautions that, like many complicated investment products, there are other costs. "There will be other fees as well. If it's derivative based there may be swap fees and forward fees – which in Canada is not quoted as part of MER," he says.

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In the case of inverse ETFs, shorting involves borrowing costs. "They need to be compared and contrasted with the borrowing costs or interest on margin," he says. "They are definitely not free."

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