Why leveraged and inverse ETPs are primarily for speculators

by Henry Cobbe, an ii contributor |

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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.

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

Type

How it works

Applications

Identifiers

Inverse

ETP gains in value if the underlying index declines in value.

Risk management: short-term portfolio insurance, dampens volatility as perfectly negatively correlated with the index.

Speculation: directional bet on a fall in the market.

-1x

 

Leverage

ETP gains in value by a multiple of the change in value of the underlying index

Risk management: there is a need to increase risk exposure to a portfolio rapidly to provide short-term profit from a rising market, without changing the core underlying holdings of the portfolio.

Speculation: directional leveraged bet on a rise in the market.

2x

3x

4x

5x

Inverse Leverage

ETP declines in value by a multiple of the change in value of the underlying index

Risk management: there is a need to decrease risk exposure to a portfolio rapidly to provide short-term protection against a falling market, without changing the core underlying holdings of the portfolio.

Speculation: directional leveraged bet on a fall in the market.

-2x

-3x

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).

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).

Case Study: Inverse Volatility Blow Up

VelocityShares Daily Inverse VIX Short-Term ETN and ProShares Short VIX Short-Term Futures ETF were products created in the US for professional investors who wanted to profit from declining volatility on the US equity market by tracking the inverse (-1x) returns of the S&P VIX Short-Term Futures Index. The VIX is itself reflecting the implied volatility of options on the S&P 500. As US equity market volatility steadily declined, the stellar performance of the strategy in prior years not only made it popular with hedge funds, but also lured retail investors, who are unlikely to have understood the complexity of the product.  By complexity, we would argue that a note inversely tracking a future on the implied volatility of the stock market is hardly simple.

On 5 February, the Dow Jones Industrial Average suffered its largest ever one-day decline. This resulted in the VIX Index spiking +116% (from implied ~12% volatility to implied ~33% volatility). The inverse VIX ETNs lost approximately 80% of their value in one day, which resulted in an accelerated closure of the product, and crystallising the one-day loss for investors. The SEC (the US regulator) focus was not on the product itself, but whether and why it had been mis-sold to retail investors who would not understand its complexity.

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.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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