Adding a little power to your ETF portfolio

GIVE me a lever long enough and I shall move the world”. So said Archimedes. Had the Greeks invented listed products, he might also have moved his stock portfolio. Leveraged exchange traded funds (ETFs), which trade like ordinary equities on the stock exchange, are now offering investors the chance to lever up, achieving the big gains (and losses) more ordinarily seen by derivatives traders.

Unlike most derivative products, however, there is no need for a margin requirement, and no possibility to lose more than your initial investment. But leverage is not necessarily a ticket to super returns. So what should investors know?

Leveraged ETFs have been around in the US for five years, but they are newer to European investors. Both ETF Securities and db X-trackers offer leveraged products that allow investors to go long and short on equities, currencies and commodities.

Typically, the products offer two times leverage daily – meaning that they aim to double the performance of the underlying index at the end of each days trading. They do that by borrowing half the share backing or by using swaps, as most db X-trackers products do. So if the FTSE 100 increases 10 per cent in one day, a double leveraged product will increase by 20 per cent, and vice versa.

According to Manooj Mistry, head of db X-trackers in the UK, that makes the products very appealing to investors without easy access to derivatives like contracts for difference or futures contracts, which might incur regulatory problems or require swap documentation. “They’re useful as a tactical investment tool if an investor has a directional view on an index,” he says. “They can also be used as a hedge, or to implement a particular tactical asset allocation view”.

Mistry is keen to stress that the products are primarily of short-term use, however. “They’ve been criticised for being dangerous investments, but they’re not – if the investor is well informed and uses them properly”. The problem is that over periods of longer than a day, compounding of volatile returns will mean that actual returns will not equal twice the index and may be substantially more or less.

As a hypothetical example, if an index dropped 40 per cent on the first day, a £10,000 investment in a twice-leveraged fund would lose £8,000 of value, while an ordinary ETF would lose £4,000. If the next day the index leapt up 60 per cent, the normal ETF would be worth £9,600, while the leveraged one would only be worth £4,400.

The greater the volatility, the greater the divergence from the index. That means that to effectively use the product as a hedge, investors will have to rebalance their portfolios day to day, potentially expensive.

Leveraged ETFs offer an interesting way to get a lot of exposure to an index through the purchase of a listed product, but they are not for everyone. The compounding of volatility means that they may offer investors deeply unpredictable returns, especially in these troubled and unpredictable times. For a few well informed investors, however, another lever available cannot be a bad thing.