If you have a strong view on the direction of the FTSE 100 or the gold price, for example, the prospect of amplifying your investment returns may sound appealing. Leveraged exchange traded funds (ETFs) can do just this but don't start investing in one unless you fully understand the risks associated with them. Here's how investors get it wrong.
Leveraged ETFs often come with a multiple in their names, such as 2x or 3x, or the name 'Ultra Long'.
If you want to bet on a market rally, these ETFs might seem to let you take extra advantage of a market increase without coming up with extra money to invest. You may think that if you invest in the FTSE 100 over the next year you will get a 7 per cent return. And how great would it be to achieve a 14 per cent via a 2x leveraged ETF. But you won't if you hold it for a year.
If you look into their descriptions they promise two to three times the returns of a respective index, which they do - sort of. The problem comes from the fact that the ETF rebalances its assets every day so that it will deliver the right multiple of the index's returns on that day. The effect of this means that leveraged ETFs don't work well over long periods.
Consider an ETF that promises twice the daily return of the FTSE 100 index such as the ETFX FTSE 100 Leveraged (2X) (Ticker: LUK2). Let's say you buy £10,000 of the ETF while the index is at 5600. If the index goes up the first day to 5700 (that's a 1.78 per cent rise) your ETF should go up twice that much, or 3.57 per cent, meaning your investment is worth £10,357. If you stay invested and the index falls back to 5600 the second day that's a decline of 1.75 per cent, which means the ETF should go down twice this much, or 3.5 per cent. A decline of 3.5 per cent on £10,357 is a loss of £362, meaning your investment is worth £9,995. So, even though the index ended up right back where it started, you have a paper loss of 0.05 per cent.
As the underlying index fluctuates up and down daily, the leveraged returns gradually decline over time, leaving you with a return that may be very different to the one you envisaged. Basically, these products are only suitable for day traders.
There are a few exchange traded products with 'monthly leverage' in their names whose leverage resets on a monthly basis. If you holding period is exactly one month, these funds should track the expected multiple of the benchmark. For longer or shorter periods, however, compounding effects will generally still cause problems.
Christopher Aldous, chief executive of Evercore Pan Asset, a wealth manager that specialises in portfolio construction using ETFs, says: "We just don't use leveraged ETFs. If you want leverage it is usually better to borrow money where you can. It is much safer to leverage via contracts for difference on a trading platform as you can get bigger exposure. You can also get the leveraged exposure through structured products if you buy the right one."
The website www.structuredproductreview.com is recommending Royal Bank of Scotland UK Accelerated Growth Deposit Plan 1, which offers the potential for an interest payment at maturity equal to 1.5 times any rise in the FTSE 100, subject to final year averaging, capped at 45 per cent.
However, be aware that any use of leverage will increase your risk exposure and can lead to greater losses.
Many investors may want to take advantage of rises in the gold price through a leveraged ETF such as ETFS Leveraged Gold (Ticker: LBUL). However, Mr Aldous says that if you want leveraged gold, you shouldn't buy a leveraged gold ETF, but instead buy gold miners. These can be a geared play on the gold price as many analysts say they are undervalued. Will Smith, fund manager of City Natural Resources High Yield investment trust, believes in a bright outlook for gold miners. You can access gold miners via an ETF such as ETFX DAXglobal Gold Mining Fund (AUCO), which has a net expense ratio of 0.65 per cent.
Also, for longer-term investors Mr Aldous points out that if the gold price goes sideways then via investing in gold miners you have equity exposure as well. Plus gold miners have increased their dividends significantly.
ETFX DAXglobal Gold Mining Fund: Top 10 holdings
| Holding | % |
| Barrick Gold | 14.4% |
| Newcrest Mining | 12.1% |
| Goldcorp | 10.3% |
| Newmont Mining | 6.6% |
| Anglogold Ashanti | 5.8% |
| Yamana Gold | 4.9% |
| Agnico-Eagle Mines | 4.6% |
| Eldorado Gold | 4.2% |
| Rangold Resources | 3.9% |
| Kinross Gold | 3.6% |
Source: ETF Securities
Short ETFs have problems too If you hold short ETFs (that produce the opposite return to the index they track) for more than a day the maths can work against you, too. Say the FTSE 100 index drops 5 per cent on the first day from 5600 to 5320. A long ETF with a starting value of £10,000 will drop 5 per cent to £9,500, while £10,000 invested in the short ETF will increase 5 per cent to £10,500. If on day two the index rebounds by 5 per cent to 5586, the short ETF will drop 5 per cent to £9,9750, while the long ETF will rise 5 per cent to £9,9750. Both end up at the same value, and both have dropped 0.25 per cent when they are supposed to be inverses of one another. |
