Short And Leverage ETPs Gaining Traction

Leverage within financial products, borrowing on top of your original capital in order to enhance returns, has been around for a long time. But leveraged exchange-traded products (ETPs) are relative newcomers still, with the first product having been launched in 2005.

Today the industry, which conflates leveraged and short products, accounts for $63 billion worldwide. The main question is whether advisers understand them, and if they are picking products at the wrong times – for example, the Coba ETC 3x Brent Oil Daily Long is down 69 percent year to date, whereas the Coba ETC 3x Cocoa Daily Long is up 11.7 percent in the same time.

How Do They Work?

The appeal of the products, according to leveraged ETP provider Boost's co-CEO Hector McNeil, lies in the ease in which they allow investors to leverage their conviction positions, in comparison to other potential sources of leverage, such as spread-betting websites or direct use of derivatives.

Leveraged ETPs are products that either track a specially created index, which will leverage its underlying, or ‘delta one’, index itself, or exchange-traded product providers can apply a leverage formula to the delta one index if no specific leverage index exists. McNeil said the result of the two processes is the same.

While these products do involve borrowing more than the investor’s starting capital – for instance if one puts £100 into a three times (3x) leveraged product, the actual amount invested in the market is £300 – investors cannot lose more than their starting capital.

This distinguishes leveraged ETPs from other leveraged products from the likes of spread betting firms, where investors can lose more than they invested.

Protections In Place

McNeil referenced the flash crash in January this year, to illustrate the point. Many spread betting investors were heavily leveraged on Swiss currency positions and couldn’t afford to pay back their huge losses. By contrast, leveraged ETPs related to the Swiss franc were “knocked out”, according to McNeil; they ceased trading when the leveraged loss hit 100 percent.

This example illustrates the key risk, but also potential upside, of leveraged ETFs; that they allow investors to take long or short bets on a range of markets with the positive or negative investment performance amplified, usually by either two or three times. So, for instance, if the FTSE 100 index rose by 1 percent on a particular day, a 3x leveraged ETP would rise by 3 percent.

However, most leveraged ETPs in the UK rebalance daily, which effectively resets the leverage. Therefore, after a week or a month, investors are likely to get a very different return than if they simply multiplied the weekly or monthly index return by, say, two or three times.

The returns generated by these products are therefore heavily influenced by compound interest – famously labelled by Einstein as 'the eighth wonder of the world'. The investor who understands it, earns it, and the investor that doesn’t, pays it.

Doing Due Diligence

“It’s quite clear you need to understand the product,” said McNeil. “The major risk is that losses can be amplified and you have got to be prepared to afford that.” Boost includes a test on its website that interested investors can take to see if they understand the products.

Ben Seager-Scott, director of investment strategy at Tilney Bestinvest, said that, from a wealth manager’s a point of view, the "due diligence at the instrument level can be quite onerous".

He said because the ETPs are synthetically replicating an index, investors need to really do their homework on the counterparty risk before buying in.

In spite of the growth in the leveraged industry in recent years, Seager-Scott said the current consensus among the wealth manager and financial adviser community seems to be one of caution towards such products. He said the widespread use of them would be "straying from traditional investment principles" which underpin wealth management.

However, he admitted having used such products in the past in order to provide a "quick and easy" currency hedge on a particular fund.

Hedging And Short Term Bets

McNeil said such hedging was actually how most investors used leveraged ETFs, rather than the image of them being used for risky speculation. However, he also said many investors also used them to make short-term tactical investments on particular themes or events, citing the Scottish independence vote and its impact on sterling as an example.

Given investors are exposing themselves to higher potential losses by gearing up, leveraged ETFs are normally seen as risky investments. However, McNeil countered such a view by pointing out that the risk still depends on the underlying asset class. For instance, he said a 3x leveraged product tracking U.S. Treasury bonds was still likely to be much less risky than a conventional 'delta 1' ETF tracking the MSCI Frontier Markets index.

Unlikely To Go Mainstream

Andrew Alexander, head of investments and product strategy at independent advisory firm Three Counties, said while he did not use leveraged ETPs himself, he understood why many investors would.

“It is the obvious method of putting on a significant position if you have a really bullish position, if you are sufficiently enamoured with a particular story,” he said.

However, he said he does not know where he would fit such products into the portfolios he runs for clients, which are all risk-rated or risk-adjusted. Given the prevalence of these sorts of portfolios within the industry, Mr Alexander said he “cannot see it coming into the mainstream”.

But as a “vehicle to enact timing”, a short-term tactical option, Alexander said investors who understand the products can certainly benefit.