Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA, CFP

Associate Portfolio Manager
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Leveraged ETFs: Not Appropriate for Long-Term Investors

If an investor believes in the long-term performance of equity markets, why would they not use leverage to invest in equities, amplifying their long-term returns?

Ideally, a leveraged ETF gives investors the opportunity to participate in amplified gains and losses as compared to the market. In theory, if an investor has a long-term belief in markets, it would be expected that holding a leveraged version of the market portfolio would yield amplified long-term gains. However, in practice, this does not hold true for a handful of reasons. Using data on HXU (an S&P/TSX 60 2x daily return ETF), HSU (an S&P 500 2x daily return ETF), XIU (an S&P/TSX 60 index ETF), and SPY (an S&P 500 index ETF), along with some discussion, we will see why leveraged ETFs are not all that a long-term investor might hope for.

  1. Psychologically, most investors are not able to handle the massive negative returns that come with leverage. In 2008, HXU returned -62.17% vs. -31.08% for XIU, and HSU returned -63.27% vs. -21.16% in CAD for SPY. The negative returns of the index have been amplified by 200%, and 300% respectively.
  1. Due to the sequence of returns being so important in long-term investing, big negative years end up dragging down the performance of leveraged ETFs. Over the last 5 years, performance has been positive for stocks, but leveraged ETFs have not fared as well as would be expected. HXU’s annualized return since its inception on January 8, 2007 has been 1.71% vs. 1.58% for XIU. HSU’s annualized return since its inception on June 18, 2008 has been 7.39% vs. 8.79% in CAD for SPY.
  1. Leveraged ETFs claim to offer exposure to 2x the index, but in practice they do not deliver. The following chart compares some past returns:

    Where we would expect HXU to return 200% of XIU, it only returned 164% and 140% over respective 3 and 5 year periods. HSU returned 160% and 151% of SPY over respective 3 and 5 year periods, again well below the target of 200%. Although these funds are able to multiply losses by 200% and even 300% (as seen in (1.) above), they do not achieve 200% tracking of positive performance.
  1. The fees and costs are high: MER (1.46%) + TER (.59%) = 2.05%.
  1. You lose the opportunity to rebalance. With a portfolio of stocks and bonds, the bond allocation can be used as a source of cash to buy more equities when equities are down. With a leveraged portfolio in an equity downturn, you’re likely to become under collateralized at some point, requiring rebalancing out of stocks (due to margin calls) when stocks are cheap.

The belief that the long-term performance of markets could be amplified using leverage seems logical; the problem is that the execution of this idea leaves much to be desired. Leveraged ETFs are designed for short-term trading, not long-term investing, and their implementation in a long-term equity portfolio is not an appropriate strategy.

By: Ben Felix & Raymond Kérzerho | 2 comments

The Next Big Call

Kyle Bass became instantly finance famous when he called the sub-prime mortgage crisis and made a handsome profit for the clients of Hayman Capital Management L.P. It would be wonderful if a manager could consistently call every large movement in the market, but perfect predictions of major events are so rare that they can propel the predictor to overnight fame.

2014 has been as difficult a year for predictions as any. Despite the media provoking Canadians to worry about rising interest rates, the iShares DEX Universe Bond Index Fund (representing the total Canadian bond market) is up 8.24% year to date. Conversely, the DFA Canadian Core Equity fund (representing the total Canadian equity market) has returned -2.40% over the same period; investors bailing out of bonds early in the year in fear of rising rates have passed up a large opportunity. The challenge of making accurate market predictions was also demonstrated when the price of oil embarked on a sharp decline. There was no way to anticipate the events and decisions that led to the price of oil dropping, and there is no way to predict what will happen to the price of oil in the coming weeks and months. The performance of bonds, stocks, resources, sectors, and geographies are interdependent and governed by so many variables that even a perfect financial model (if it were to exist) is subject to massive variances based on its underlying assumptions. As inconsistent as market predictions are, the financial media and the institution of active management thrive on the human desire to be on top of the next big call.

Rather than wrestling with CNBC’s latest tip, smart investors stay disciplined and maintain their portfolio based on a well-designed framework. Discipline starts with the thoughtful and involved creation of an Investment Policy Statement. This written document becomes the foundation for all future investment decisions; it is a long-term strategy that provides rules-based guidance when short term market movement causes psychological stress. The practical maintenance of an Investment Policy Statement is carried out through rebalancing. Rebalancing is a simple concept that rewards the long-term investor, though it can be a psychologically challenging process. It involves buying assets that have gone down in price, and selling assets that are performing well – something that can seem counterintuitive when the media, and most investors, are obsessed with catching the next hot thing.

Whether or not there is an advisor involved, the investor that builds an Investment Policy Statement and rebalances to their target allocations will see volatile markets as opportunities to increase their expected returns rather than scary and unexpected times that might warrant going to cash. Important investment decisions should be based on rules, not on the next big call.

By: Ben Felix | 0 comments

The Growing Momentum of Index Investing

Index investing, passive investing, and market-based investing are synonymous terms for an investing approach that has seen a steady increase in popularity over the last decade. The idea that any investment manager is able to produce superior returns that beat the market has been consistently eroded by their evident inability to do so. There is very little evidence that any individual or firm that engages in active management is able to predictably produce the market beating returns that would justify their high fees. Contrarily, the evidence in favour of index investing has continued to build, and it has not gone unnoticed.

Through 2014, the media has had a field day exploiting the data that is making both institutional and retail investors question their approach to financial markets. Back in May, The Economist had a headline reading “Cheap is cheerful” followed by a discussion of the industry’s imminent shift toward low-cost index funds. In August, a Wall Street Journal headline read “The Decline and Fall of Fund Managers” followed by the statement that the debate between passive and active management is over. The New York Times shunned active management in July with the headline “Heads or Tails? Either way, You Might Beat a Stock Picker,” explaining that over the last five years, actively managed stock mutual funds have performed even worse than would have been predicted if the fund managers were flipping coins instead of picking stocks. Another July headline from the New York Times read “Who Routinely Trounces the Stock Market? Try 2 Out of 2,862 Funds”. TIME Magazine’s September 18th headline read “The Triumph of Index Funds” after the California Public Employees’ Retirement System began shifting assets from active management and hedge funds into passively managed index funds. This media trend of bashing active management was present in Canada too, as National Post’s headline “Andrew Coyne: Canada Pension Plan’s active management strategy is a crock” clearly indicates. It didn’t help the case for active managers when Warren Buffet stated in his annual letter to Berkshire Hathaway shareholders that his heirs are to invest their inheritance in low-cost index funds.

Investors are voting with their dollars. In the retail market, the Vanguard Group (which manages mostly index funds) has taken the lead as the largest mutual fund firm in the world, with over $3 trillion in assets. As at September 2014, Vanguard had seen $57 billion of inflows to passively managed products for the year while investors pulled $59 billion from their actively managed stock funds. Vanguard’s experience is not unique. A recent survey from Cerulli Associates established that the market share of retail index funds has increased from 13% to 24% in the last ten years. Retail index funds have gathered more money than actively managed funds in the U.S. in four of the last six years. Canada is lagging behind this trend with index funds capturing a modest 6% of market share according to BMO Asset Management. It can be speculated that this is attributed to Canada’s distribution network consisting largely of commission-based sales people who are not motivated to recommend index funds, whereas the US is largely shifting away from commissions to the fee-based model.

On the institutional front, Cerulli Associates found that the vast majority (88%) of the U.S. institutional investment managers they surveyed expect the market share of institutional index funds to exceed 20% in the coming three to five years, and almost four out of ten institutional managers believe this market share will even exceed 30%.

The bottom line: An overwhelming amount of data shows that investors are better off cutting their costs and investing in the index rather than paying high fees for unreliable promises of outperformance. Following this evidence, as the media and investors are starting to do, will lead to an increasingly positive investment experience.

This blog post was written in collaboration by Benjamin Felix, PWL Investment Advisor and Raymond Kérzerho, PWL Director of Research.

By: Ben Felix & Raymond Kérzerho | 0 comments