Summary
Regulatory concerns over leveraged and special ETFs are justified because the most popular funds lack transparency and could be marketed more accurately. This is not the case however for all ETFs, some simply “do what they say on the tin”.
The differences between three very different types of leveraged long ETFs are analyzed briefly:
Simple leverage
“CPPI” based
“futures” basedAnalysis
The mechanism of some of the best selling leveraged ETFs has to be described as rather unclear, so it is hardly surprising that the regulators expressed some concerns. If an ETF is defined as a fund that replicates exactly a benchmark index one could even be surprised by how those instruments could be classified as ETFs in the first place. FINRA message encourages the investor to “do his homework” before investing as there is a big discrepancy between the marketing and understanding of the instruments on one side and the reality that appears only in the small print on the other side.
The concerns are very clearly listed and explained with example on the site of the FINRA, so one should refer to it for more details:
- Risk that ETF might not reach its stated objective
- Resetting daily
- Cost and tax consideration
The concerns are very clearly listed and explained with example on the site of the FINRA, so one should refer to it for more details:
- Risk that ETF might not reach its stated objective
- Resetting daily
- Cost and tax consideration
There are three main types of leveraged long ETFs:
Simple leverage:
The ETF mechanism is simply replicating what an investor could, in theory, do himself by investing in the asset and borrowing an equal amount to double its position.
The Payoff: Notional x (1+ 2 x asset performance – borrowing cost) is straightforward
A Stop Loss is required as the investor could in theory lose more than his capital, so there are provisions such as “if the index drops by more than [10-15%] the leverage will stop”.
A significant advantage of simplicity is the monitoring: the strategy can be replicated by an index provider who can maintain a “new reference index” that follows exactly the above payoff. Using a swap the ETF provider can then deliver exactly (minus fees) the performance of that “new reference index”, which gives a perfectly clear picture to the investor.
Example: CASAM leveraged EuroStoxx50 ETF
The ETF mechanism is simply replicating what an investor could, in theory, do himself by investing in the asset and borrowing an equal amount to double its position.
The Payoff: Notional x (1+ 2 x asset performance – borrowing cost) is straightforward
A Stop Loss is required as the investor could in theory lose more than his capital, so there are provisions such as “if the index drops by more than [10-15%] the leverage will stop”.
A significant advantage of simplicity is the monitoring: the strategy can be replicated by an index provider who can maintain a “new reference index” that follows exactly the above payoff. Using a swap the ETF provider can then deliver exactly (minus fees) the performance of that “new reference index”, which gives a perfectly clear picture to the investor.
Example: CASAM leveraged EuroStoxx50 ETF
CPPI based
CPPI (Constant proportion portfolio Insurance) is an algorithmic rebalancing methodology (commonly used to build capital protected products without using options). It is fully transparent but complex. In very short: as in the above example a stop loss level is defined and the leverage is not constant but calculated depending on the distance between the asset performance and that stop loss level. As the index goes up the leverage increases and vice versa. However this simplistic explanation is much too light to get a precise idea of a payoff that requires many pages and heavy formulas to be explained. This payoff has been used frequently for retail products in the past but has so often been followed by complaints that it is much less favored nowadays.
Example: SGAM leveraged CAC ETF
CPPI (Constant proportion portfolio Insurance) is an algorithmic rebalancing methodology (commonly used to build capital protected products without using options). It is fully transparent but complex. In very short: as in the above example a stop loss level is defined and the leverage is not constant but calculated depending on the distance between the asset performance and that stop loss level. As the index goes up the leverage increases and vice versa. However this simplistic explanation is much too light to get a precise idea of a payoff that requires many pages and heavy formulas to be explained. This payoff has been used frequently for retail products in the past but has so often been followed by complaints that it is much less favored nowadays.
Example: SGAM leveraged CAC ETF
Futures Based?
The question mark is left on purpose as for most of the largest leveraged ETFs it is hard to find a detailed payoff in the prospectus, on the contrary this document generally indicates that the provider can use a large array of underlying and strategies. A detailed examination tends to show that the strategy are mostly based on a daily roll of futures, which is are indeed a very efficient way to get a high leverage depending on your margin requirement (leverage can be much higher than x2 or x3). However the exact mechanism is not clearly defined and providers are clearing themselves of any wrongdoing by using prospectuses who look more like disclaimers. With the multiple use of many “if”, “should”, “approximately”, the investor is warned many times that the fund may not meet its objectives and that it can invest in various underlyings and derivatives.
This kind of ETF is lacking transparency and even accountability as its objectives seem rather weakly defined. It is however the type of leveraged ETFs that account for the largest volumes.
Example: Proshares "Ultra" on various indices
The question mark is left on purpose as for most of the largest leveraged ETFs it is hard to find a detailed payoff in the prospectus, on the contrary this document generally indicates that the provider can use a large array of underlying and strategies. A detailed examination tends to show that the strategy are mostly based on a daily roll of futures, which is are indeed a very efficient way to get a high leverage depending on your margin requirement (leverage can be much higher than x2 or x3). However the exact mechanism is not clearly defined and providers are clearing themselves of any wrongdoing by using prospectuses who look more like disclaimers. With the multiple use of many “if”, “should”, “approximately”, the investor is warned many times that the fund may not meet its objectives and that it can invest in various underlyings and derivatives.
This kind of ETF is lacking transparency and even accountability as its objectives seem rather weakly defined. It is however the type of leveraged ETFs that account for the largest volumes.
Example: Proshares "Ultra" on various indices
The same mechanisms can be used on shorts as well, with the additional complexity that a short ETF even in its simplest form has to use a daily resetting mechanism.
This is not a recommendation to buy any type of ETFs. Transparency and clarity is one important factor where there is a clear distinction between providers, and investors should make the effort to navigate their way through the prospectus before buying, although undoubtedly not all investors do that. However there are many additional factors to consider when buying ETFs, such as fees, liquidity, counterparty risk, tracking error and more.
This author consults with leading institutions through GLG
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
