Why leveraged and inverse ETPs are primarily for speculators

While they can have a short-term role to play, they should be handled with care. If you think you understand them, then you’ve only just begun, says Henry Cobbe.

This is the seventh in a series of articles by Henry Cobbe, head of research at Elston Consulting, exploring the world of index investing. Henry is author of How to Invest With Exchange-Traded Funds.

For speculators and/or more sophisticated risk managers there are a range of inverse (short) and leveraged (geared) ETPs that can rapidly add or remove upside or downside risk exposure in short-term (daily) market movements.

The difference between speculating and investing should be clearly defined.

• Investing implies a disciplined, rational approach to seeking a commensurate level of expected return for a given level of risk using the investor’s own capital.
• Speculating implies an unstructured, emotional approach to seeking outsize levels of possible return at any level of risk using the speculator’s own or borrowed capital.

Owing to the higher degree of risk management and understanding required to use these products,  they may not be suitable for DIY or long-term investors. However a degree of knowledge is helpful to identify them in a managed portfolio or among research sites.

Defining terms

Unlike their more straightforward unleveraged ETF cousins, leveraged and inverse or “short” ETNs should be for sophisticated investors or professional use only. So hold on to your seat. Shorting and leverage are important tools in a professional manager’s arsenal. But first we need to define terms.

Going long: this means buying a security now, to sell it at a later date at a higher value. The buyer has profited from the difference in the initial buying price and final selling price.

Going short: this means borrowing a security from a lender and selling it now, with an intent to buy it back at a later date at a lower value. Once bought, the security can be returned to the lender and the borrower (short-seller) has profited from the difference in initial selling and final buying price.

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Leverage: thismeans increasing the magnitude of directional returns using borrowed funds. Leverage can be achieved by:

• Borrowing (on a secured or unsecured basis) from a lender to invest in risk assets in the expectation that the returns are greater than the interest rate charged for borrowing those funds. Use of borrowing within ETNs to create Leveraged ETNs introduces interest costs into the overall cost of the ETN.
• Options: leverage can be achieved synthetically by buying call options (the right to buy a stock (including ETFs on whole markets) at a certain strike price in the future. As markets move further away from the strike price, the value of that option increases exponentially. A leveraged short position can be achieved by selling call options.
• Contracts for Difference (CFD): leverage can be achieved synthetically by entering into a contract for difference (where one party contracts to pay the other party the difference between a current value and the value at the start of the contract). The buyer can use current cash and trade on margin that is based on the size of the trade. Effectively, it means buyers of CFDs only need a small amount of capital to access a much larger position.

Underlying index: this is the underlying index exposure against which a multiplier is applied. The underlying index could be on a particular market, commodity or currency.

Potential applications

Managers typically have a decision only whether to buy, sell or hold a security. By introducing products that provide short and/or leveraged exposure, this gives managers more tools at their disposal to manage risk or to speculate. Going short and using leverage can be done for short-term risk management purposes, or for speculative purposes. Leverage in either direction (long-short) can be used either to amplify returns, profit from very short market declines, or change the risk profile of a portfolio without disposing of the underlying holdings.

Short/Leveraged ETPs available to DIY investors

The following types of short/leveraged ETPs are available to implement these strategies.

Potential application of inverse/leveraged ETPs

Source: Elston, for illustration only

The ability to take short and/or leveraged positions was previously confined to professional managers and ultra-high-net-worth clients.  The availability of more complex Exchange Traded Products gives investors and their advisers the opportunity to manage currency risk, create short positions (profit from a decline in prices) and create leveraged positions (profit more than the increase or decrease in prices).

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Risks

Leveraged and short ETPs have significantly greater risks than conventional ETFs. Some of the key risks are outlined below:

• Complexity: short and leveraged products are complex products making them harder to understand and deploy.
• Counterparty risk: furthermore, short/leveraged ETPs carry bank counterparty risk, as they are swap-based agreements, unlike traditional ETFs, which are physical and own the underlying asset.
• Decay: leveraged products exhibit decay (their ability to perfectly track an index with leverage) diminishes over time from the combined effects of fees and expenses, rebalancing costs and volatility decay[1].

If concerned regarding risk of deploying short/leveraged ETPs, set a capped allocation (e.g. no more than 3% to be held in leveraged/inverse ETPs, and a holding period for leveraged/inverse ETPs not to exceed one to five days).

Summary

In conclusion, on the one hand, Leveraged/Inverse ETP are convenient ways of rapidly altering risk-return exposures, and provide tools with which speculators can play short-term trends in the market. Used by professionals, they also have a role in supporting active risk management. However, the risks are higher than for conventional ETFs and more complex to understand and quantify.