Is There a Place for Leveraged ETFs in my Portfolio

By: Raymond Kerzérho

At PWL, our investment philosophy has always been based on the belief that active managers cannot consistently beat market indices over time.

That belief, coupled with our desire to capture market returns at the lowest possible cost, had led us, for over a decade, to the decision of building our client portfolios using exchange-traded funds (ETFs) as one of the primary components.

But, as ETFs have evolved and increased in popularity, many variants have emerged. One of these are the inverse and leveraged ETFs, which use derivative products to create a short position or a higher level of exposure to an index. The inverse ETFs are structured to produce a positive return when the index return is negative (and vice versa), while a leveraged ETF aims to double the return of the underlying index on a daily basis. In order to do this, it holds a large amount of cash invested in short-term securities, and a smaller but highly volatile portfolio of derivatives, such as index futures, equity swaps, and index options.

There are several risks to these products:

1. As with any leveraged investment, the risk is magnified considerably.
2. The complex structure of these products results in management expenses which are much higher than non-leveraged ETFs.
3. This type of product is designed to be held for only a few days.

If held as a long term investment, the return on these products may be different from what was reasonably expected. For example, in 2008, a US-listed inverse ETF on Emerging Markets produced a deep negative return while its underlying index also prod­uced a negative return, where in theory it should have been positive. This happened because the composition of inverse/leveraged ETFs is rebalanced daily, which makes their longer term results unpredictable.

It is our view that, given these drawbacks, leveraged ETFs are unacceptable for our client portfolios. I encourage you to contact your PWL advisor if you would like further information.