Risk outweighs benefits of leveraged ETFs

What are Leveraged ETFs?

Leveraged ETFs can be defined as Exchange Traded Funds that use a combination of derivative and debt to enhance returns for investor. Here is a simple example of how a leveraged ETF works. Let us say a leveraged ETF tracks the S&P 500 Index.

Assume that for every invested dollar in the fund, it uses $1 in debt. Now, if the index moves up by 1%, the fund will give the investor a return of 2%. So, for every $100 invested by the investor, they will get a return of $2 in a leveraged fund, whereas in a normal ETF, return will be merely $1.

Of course, there will also be transaction cost, management fees and the interest on the debt, which will reduce some of the return on a leveraged fund. So, the investor who invests $100 in such a fund will probably make $1.50, if the index moves up by 1%. That is 50% more than what they will make in a normal fund.

But, is the risk worth taking?  We don’t think so.

Why Leverage is not a great idea?

Well, a lot could go wrong if you are leveraged. One just needs to look back at the financial crisis and see how dangerous leverage can be.

Banks and hedge funds that went bust during the financial crisis were all highly geared. Even before the financial crisis, there have been hedge funds that have gone bust because they were highly geared.

From Long Term Capital Management, the famous hedge fund that had Nobel laureates in its ranks, to Amaranth, whose star trader was one of the highest paid hedge fund managers in the world at one time; there have been many funds that have collapsed due to high leverage.

Lehman Brothers, the investment bank that survived the Great Depression, collapsed in the financial crisis as it was geared 40 times, i.e. for every $1 of equity; Lehman was using $40 in debt.

Now, you stand to make a stellar return on equity if things go in the direction you want them to go, but can go horribly wrong if they go only slightly against you. And leveraged ETFs are no different.

So what could go wrong with a Leveraged ETF?

Let us look at an example of how things could go wrong in a leveraged ETF. Suppose you have a leveraged ETF that is tracking the Japanese Index. Now, let us assume that the fund is geared 3 times, i.e. for every $100 invested in the fund; it uses $300 in debt. If the Japanese Index moves up 1% – the direction you want it to move because you are long the index – you make $3. After deducting all the costs, you are left with $2.50. A decent return, and more than what you could have made in normal fund. But, if the index moves in the opposite direction, i.e. it goes down by 1% you have lost 3% of your equity.

And imagine how the loss will accentuate if the index drops by 10%. You would lose 30% of your equity in just one day. And let us say you were geared 4 times instead of 3. Now you lose 40% of your equity. No wonder that highly geared banks and hedge funds were wiped out in a day.

Understanding how leveraged ETFs work

One very important thing for investors is to understand is how these leveraged funds work. A fund that is geared two times, promises to generate double the return of the index it is tracking. Theoretically, this means that if the Dow Jones returns 20% in a year, a 2x fund should return 40%. However, this is not the case as the fund tracks daily changes in an index and so they may double your daily return, but things could be different when we talk about annual returns.

Let us get back to the $100 we had invested earlier. To simplify the example, we are not assuming any costs and management fees for the fund. Now, if the index goes up 10%, you gain 20%, assuming the fund is geared 2 times.

So, your $100 is now $120. Because the fund has to balance the leverage ratio and keep it at two times, it will have to adjust the debt level by increasing it by $20. So, now you have $120 in equity and $120 in debt.

Now, the next day the same index drops 10%. You lose $24. Your equity is now down to $96. So, you have lost more than the index. Yes, on a daily basis, your gains and losses are double that of index. But over a two day period you have lost $4, 4 times what the index lost. If you were invested in a normal ETF, you would have been at $110 after the 10% gain on day one, and been down to $99 after the 10% loss on day two. So, overall, you would have lost $1. But with a leveraged ETF, you stand to lose $4, 4 times what you would have lost in a normal ETF.

Tracking Emerging and Frontier markets

Till now, we have only spoken about leveraged ETFS. What if you have a leveraged ETF that tracks an index of an emerging or frontier country? Yes, you can make a lot of money by investing without using any leverage. Imagine the returns you can make if you are geared. There are ETFs that track indexes of some of the most volatile stock markets in the world. Some of these markets see huge jumps and falls on daily basis. And like we explained earlier, daily changes can have tremendous impact on leveraged ETFs.

Leveraged ETFs on indexes of volatile markets can generate stellar returns, if the markets go in the favored direction. But, investors stand to lose big time, if their bet goes wrong.

A final word

Through this article, we have explained the effect leverage can have on your returns. Using leverage to enhance returns is a great idea, if you can predict the direction in which the markets will move. Some years ago, Long Term Capital Management thought it could do this, with the help of a star studded team and the most sophisticated investing strategies.

But, it only took a few days of losses and the fund went bust.