Our Privacy Statment & Cookie Policy

All LSEG websites use cookies to improve your online experience. They were placed on your computer when you launched this website. You can change your cookie settings through your browser.

June 8, 2020

Levered ETFs: Helpful Tool or Hidden Danger?

by Robert Jenkins.

Levered ETFs have been called out of late by major ETF promoters expressing concern that their naming conventions are in need of fine tuning. The argument is these products are currently lumped into the general category of ETFs/ETPs (exchange traded products) which has a benign connotation given that most ETFs are fairly straightforward index replication funds largely considered inherently diversified and relatively safe. For this reason, retail investors may not be fully aware of the make-up of some of the riskier products out there and find themselves with some unforeseen outcomes as a result.

That larger ETF managers would want to separate these products out into a new category isn’t unusual in itself since these products always pop out of the league tables during major market events—with accolades as both the best and worst performing funds in the market. Retail investors often focus on the top of those tables, and they tend to value recent performance as an indicator of future results. Others are legitimately attempting to generate a certain outcome, such as increasing returns by placing a bet on the price of oil or gold or juicing up dividend payouts from income producing securities. But are these products helpful tools or do they harbor hidden dangers for unwitting investors? First, let’s take a look at some sample returns.  The exact name of the fund and promoter are left aside but the basic strategy is called out and the unlevered returns of the S&P 500 are at the top for a comparative baseline.

One can see the eye-popping nature of these numbers and envision being right about your bets and seeing incredible returns—or not. Certainly, you’d be happy if you got into the 2X VIX product in January—you would have enjoyed a 200% return in the month of March alone. But what if, at the beginning of this year, you felt the price of oil would start to increase as we moved into the spring and summer traveling season? This is not a far-flung strategy by any means if you didn’t know that COVID-19 was coming or that there would be a breakdown of understanding among oil-producing nations.

The energy markets were an interesting place to be during the first quarter, with oil futures briefly negative at one point. An unwitting investor who was long levered ETFs in this sector could see month-on-month negative returns ranging from 30% up to 100%. As with the oil and energy space, similar results befell investors with levered positions in other COVID-sensitive sectors such banking, real estate, and retail, and even country-focused products covering hard hit areas such as Brazil and Russia. There are several of these products that are not only levered, they are based on already volatile strategies to begin with, thus furthering their near gambling-like nature.

But perhaps the more poignant cautionary tale is the products that attracted investors seeking income, who are often retirees. Note in the chart the 2X high dividend low volatility fund that printed a loss of 60% in March. If you allocated a large part of your nest egg to a fund like this in order to pump up your monthly income stream in a low rate environment, you could have suffered devastating losses, and there are stories out there of retired investors who experienced just that.

Also of note is the unevenness of how these products operate. Some of the levered crude oil funds saw a rebound in April, while others didn’t. It all comes down to the strategies being employed underneath. Are they based off of energy stocks, commodity futures, or some other synthetic mixture of assets? Many investors may not understand how these different portfolio construction devices might behave, so they may not know why these differences are important. After all, they all look like oil tracking ETFs on their face.

So, it’s clear these are some powerful vehicles, but are they so dangerous as to warrant a new naming convention? It’s arguable that simply renaming them “exchange traded instruments” isn’t going to do too much to thwart unwitting and potentially ill-suited investors from trying their hands at these “lottery tickets.” So, is more needed? The fact is, the world of ETF investors has a heavy institutional presence in it as well, and these products can be used as hedging and alpha generating vehicles by knowledgeable investors—similar to how options and futures have been used for decades. That said, retail investors using put and call options contracts typically need to gain additional approvals from their brokers by acknowledging the reading of risk disclosure documents and generally verifying their abilities to assume such risks. The same is true with often riskier private investments such as hedge funds or private equity funds in which investors need to prove they are accredited.

It’s arguable that similar additional measures describing the risks and verifying the ability to assume them would be more helpful to protect retail investors than a simple change in the acronym.

Lipper delivers data on more than 265,000 collective investments in 61 countries. Find out more

Get In Touch

Subscribe

We have updated our Privacy Statement. Before you continue, please read our new Privacy Statement and familiarize yourself with the terms.x