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Extreme Investing - Eureka Report article
Extreme investing
By Scott Francis
December 17, 2010

PORTFOLIO POINT: They offer a low-cost way to get diversified exposure, but leveraged ETFs could be a low-cost way of getting into trouble.

The global market for ETFs is about $US1 trillion and growing every day. Mostly based around popular indices like the S&P 500 or the FTSE 100, they are a cheap and efficient way for investors to access growth assets and employ tactical tilts.

But over the past few years some ETFs have been criticised for becoming too complex, especially in the US where different examples have begun to feature everything from commodities, short positions and leverage.

So back in January when most of Australia was still on holidays, the ASX quietly launched two new indices – the S&P/ASX 200 2x Leverage Daily Index (XLD) and the S&P/ASX 200 2x Inverse Daily Index (XNV) – indices that appear to be just waiting to be the subject of ETFs.

The ASX media release announcing the indices says the first, XLD, represents a leveraged exposure to the ASX 200 and the second, XNV, represents a leveraged short position in the ASX 200.

During the global financial crisis the Australian market fell by more than 50% for only the second time in its history. Such volatility leads people to think about strategies that they can use to protect their portfolio from a downturn.

If you had invested in a leveraged ETF with a loan-to-valuation ratio of 50% during this period then you would have blown yourself up. But had you invested in a leveraged inverse ETF with a loan-to-valuation ratio of 50% then you would have made a pretty penny.

Let’s explore that notion further.

The expectation is that the move in the 2x Inverse Daily Index will be about twice the move in the underlying index, in the opposite direction. It will not be exact because adjustments are made for interest payments and dividends.

The following table compares the move in the ASX 200 index with the move in the ASX 200 2x Daily Inverse Index. Over the 10 trading days the average return in the ASX 200 was 0.3% a day, while the average return from the ASX 200 2x Daily Inverse Index was –0.54%. This is what we would expect: a return close to but not exactly twice the size in the opposite direction to the index.

There are various uses for an ETF like this.

For example, commercial investment managers might use it to protect the value of a portfolio from a market downturn while selling down investments over time. For an individual investor, I suspect that the most common use would be by investors who think that markets are about to fall, and want to take an aggressive position to profit from that.

The returns from the popular US-based Rydex Inverse 2x S&P 500 Index do not make for great reading. To start with, it has management costs of 0.7% a year – very expensive for an ETF.

Over three years to December 10, the average annual return has been –13% a year. This seems to be a surprisingly poor result for investors, given that the past three years (end of 2007 to end 2010) has included one of the biggest sharemarket downturns in history.

A look at the chart of the share price of the Rydex Inverse 2x S&P 500 Index is interesting. It listed at the end of 2007 at $75 a share, as markets were around their pre-GFC highs. Towards the end of 2008 (the collapse of Lehman Brothers) it had increased in price to nearly $200 – almost trebling investor's money. However, the subsequent recovery has been tough on investors, with the ETF now trading at less than $40, or just over half of their original investment.

Not happy with just a 2x Inverse Index, various ETFs in the US offer investors the chance to take a position using a 3x and 4x inverse indices – a large bet on sharemarkets falling.

The last question is: are these really suitable for individual investors? For example, should an ETF like this, if launched in Australia, find its way into self managed super funds?

The challenge with this investment seems to be two-fold. First, you are taking a bet against a long-term trend. The average return from Australian sharemarkets over long periods (starting before 1900) has been about 12% a year. An article by Paul Kerin of the Melbourne Business School, showed that the average total return from Australian shares in the period 1925 to 2009 had been 11.9% a year. So, in any given year the sharemarket return has to be about 12% below the average for an investor to profit from an inverse position.

Further, adding leverage adds to the potential damage. The US Rydex ETF shows how quickly the great gains made by a 2x inverse ETF are destroyed by a recovery.

There are also various pieces of evidence that suggest as individual investors we are terrible at knowing when to get into and out of markets (see The market timer). For example, the US financial services firm Dalbar uses data of when investors make and withdraw investments in share funds to show the return they actually receive from investing in sharemarkets.

Over the 20 years to the end of December 2009, the average annual return from sharemarket in the US was 8.2% a year, whereas the average investor received a return of just 3.2% a year – because they tended to buy when shares were high and sell when they were low. Adding leverage to this poor timing behaviour could destroy significant wealth.

In Australia, according to Reserve Bank data, we can see that at the height of the market (December quarter 2007) Australians had $38 billion in margin loans. By the low of the market, in March 2009) this had shrunk to less than half: just $18 billion. This was the opposite of how people should use leverage to create wealth: people with share investments in December 2007 have received a terrible rate of return; those with investments in March 2009 a great rate of return.

Overall, the poor ability of investors to know when to get in and out of markets, coupled with the difficulty of betting against the historical long-term tendency of sharemarkets to rise means a 2x inverse ETF could do lot of damage to an investment portfolio; 3x and 4x inverse ETFs could do it even faster.

The creation of the S&P/ASX 200 2x Leverage Daily Index and the S&P/ASX 200 2x Daily Inverse index is an interesting addition to the Australian financial landscape. Assuming that the Australian follows what happens in the US, the development of an ETF of managed investment that tracks such an index might not be far away.

As much as it offers the chance for a high conviction bear to “put their money where their mouth is”, it seems that it will be only suited to those few individual investors who are comfortable with taking extreme investment risks. For the rest of us, moving money from shares into cash provides a more appropriate way of managing concerns about a fall in share values.