Leveraging on lessons learned

As investors increasingly turn to ETFs for low cost long exposure, negative press on leveraged and inverse products has left some investors wary. Emma Dunkley looks at what the industry has learned and the benefits on offer

As ETF assets continued to soar during the summer months, a part of the ETF landscape came under fire in the US amid controversy surrounding certain leveraged and inverse funds. Losses suffered by investors of these particular products drew negative attention, which culminated in a notice issued by the Financial Industry Regulatory Authority (Finra). The regulatory body reminded advisers about product suitability obligations and highlighted some of the risks entailed by inverse and leveraged ETFs, noting these funds are not typically suitable for retail investors who plan to hold them for longer than one day.

The notice spurred industry players, including advisers and brokerage firms, to highlight how these leveraged and inverse products work, the risks involved and their suitability for particular clients. Yet the notice also provoked impulsive reactions among some. Direxion Funds marketing director Andy O’Rourke said: “What happened over the summer was an interesting time; we had Finra launching a notice, which lead to a few broker dealer firms making knee-jerk decisions to ban these types of funds.” 

How funds work

The situation concerning particular leveraged and inverse funds seemingly stemmed from a lack of awareness as to how they worked. A fund leveraged by two times, for example, is designed to deliver two times the daily performance of the underlying index. This leveraged exposure to the underlying index is reset, or compounded, on a daily basis in order to provide the daily return. As a result, the fund’s performance can largely differ to the cumulative return of the index over periods other than a day. 

O’Rourke explained that not all funds are suited to all investors and certain leveraged and inverse funds should be used by investors seeking short-term trading activities. However, he expressed concern regarding Finra’s emphatic statement that leveraged and short ETFs should not be held for longer than a day. Instead, he argued this is possible as long as the products are monitored closely and managed, allowing investors to see if their position is perhaps over-exposed due to compounding. Consequently investors could reduce their exposure by removing some capital and could then place it back into the position when the market corrects. 

Positive elements

Although there is a need for further education, providers are also highlighting the benefits of leveraged products. ETF Securities co-head of European sales Scott Thompson said leveraged or daily percentage change products, as opposed to standard price change products, are great for trending markets such as the one at present. For example, he said rather than receiving two times the period return, this could be higher in a trending market due to the daily compounding. He added: “You can get outperformance when the market is trending over multiple days, for example, if the FTSE 100 index goes up three or four days in a row.”

Arguably the most significant benefits include the ability for investors to gain leverage with downside protection, in terms of not losing any more than the initial investment. Thompson said: “The trouble with a futures position is you can lose a lot more than your initial margin. If you buy a future and the market declines, you’re going to have margin calls against you, and you could end up paying out more than your initial margin.” 

Conversely, Thompson said as leveraged ETFs reset and adjust positions each day, the investor is guaranteed to lose no more than the initial investment. He explained that, as a result, ETFs place a cap on potential maximum loss, which does not exist for trading futures, contracts for differences or option positions. He said: “In terms of negative press, this is rebalancing now as people are realising that with other leveraged instruments out there, you can possibly lose a lot more than your initial investment.”

Similarly, inverse ETFs provide a way for investors to gain short exposure which they might otherwise find hard to obtain. Manooj Mistry, head of db x-trackers UK, explained traditional means of shorting through derivatives such as futures or swaps, or by borrowing the ETF or individual index component, may not be practical or even possible for every investor. He said: “The daily short index ETFs provide an alternative for investors who cannot gain short exposure through derivatives or shorting equities.” 

Inverse ETFs also offer the benefit of limited downside exposure, which tends to be unlimited through other means of shorting. Mistry said: “In a worst case scenario, an investor in a short daily index ETF cannot lose more than their initial investment.” Db x-trackers claims to offer the largest range of short daily index ETFs in Europe, with over €2bn in assets and 22 products, comprising 15 on equities, six on credit markets and one bond fund. The ETFs track the performance of an independently calculated short daily index from providers including Stoxx and Standard and Poor’s. 

Shorting issues

In comparison with inverse ETFs, other methods of shorting have more parameters potentially affecting their position, which need to be considered, according to BNP Paribas head of EasyETF Guillaume Dolisi. For example, he said the parameters affecting options include time, volatility, and the price of options, whereas short ETFs just have the specificity of daily compounding. He said: “It’s the only specificity, so you can understand it and work with it, while other methods of shorting the market, such as put options, require many more parameters to be taken into account.” 

Dolisi said that whereas larger institutional clients are able to use futures and options for shorting, taking into account these parameters, retail and smaller institutions which may not have these capabilities are showing interest in the short ETF range. For example, EasyETF offers double short funds on the Eurostoxx 50, Stoxx 600 and the Cac 40. Dolisi added: “For many small investors, ETFs are easy to set up for shorting purposes, compared with what needs to be put in place for other shorting solutions.” 

Investors remain cautious

Yet some investors are still wary and maintain certain products do not meet their risk-averse profiles. Spencer-Churchill Miller Private (SCM) fund manager Alan Miller said the firm’s two portfolios solely comprise ETFs, although they have never used any short ETFs. He said that as inverse ETFs rebalance daily, the charges and therefore performance can significantly differ to the inverse of the underlying index over the medium term. He said: “Unless one uses them for intra-day trading, which is something we do not do, then the odds are stacked against you.” He added that, in most circumstances, it is better to short the relevant index or borrow short the actual ETF, rather than buy a short ETF. 

In terms of long exposure, SCM uses ETFs for going long for every asset class it invests in, which currently includes UK, European, Japanese and Far Eastern equities, UK and US corporate bonds, UK and US inflation-linked government bonds, currencies and commodities. Miller said: “In my view, ETFs are a fantastic vehicle for going long almost any asset class.” He said he would be more tempted to use short ETFs if they performed as a mirror of ETFs. He explained this could be achieved if a provider offered a borrowed ETF facility where the return would be the inverse of the long ETF, minus the cost of borrowing. 

Similarly, Evercore Pan-Asset Management almost exclusively uses ETFs for implementing asset allocation decisions for going long. The firm’s chief executive Christopher Aldous said: “We don’t go short and we also don’t leverage; we have a mantra of keeping it simple and we think complexity adds risk.” In terms of going long, Aldous said one of the benefits of futures is investors only need to use a fraction of their capital to gain leverage and then have the remaining capital to implement elsewhere. 

However, he said futures require professional management, entail costs of rolling them over each period and are not typically suitable for the average investor. He added: “The beauty of ETFs is someone with £50 can go and get long only exposure to virtually any asset class, including quite sophisticated trades such as commodities and currencies.”

Yet Aldous warned if individuals buy ETFs directly, they are not covered by the Financial Services Compensation Scheme. He said: “If you’re advised by a regulated entity, such as an independent financial advisor or ourselves, you’re covered. ETFs alone are not covered because they are off-shore investments.” He explained that he receives enquiries from investors who do not want to pay for advice and would rather invest themselves online. He added: “They can, but investors have to be aware that they’re not protected in the same way.”

While the ETF industry may have been alerted by negative coverage surrounding leveraged and inverse funds, the situation has provoked further education on these trading tools. As ETFs continue to be the vehicle of choice for going long for many players, there is still potential for increased usage of short and leveraged ETFs, which will likely develop as the market matures.