5831 where next for leveraged etfs itemid 127

Blog
     
SAVE AND SHARE Digg Del.icio.us Reddit Newsvine RSS


Where Next For Leveraged ETFs?

Written by Paul Amery

  
Wednesday, 13 May 2009 16:24 (CET)

Hartmut Graf, head of the index team at the German stock exchange in Frankfurt, gave a fascinating talk on leveraged indices at yesterday’s “Investing in ETFs” conference, organised by Financial News.

Graf started his presentation by recalling the basic fact about these indices – that they do not track the “equivalent” multiple of the underlying index return if held over long periods. Why? Because the simple effect of compounding and rebalancing on a daily basis leads to significant tracking error.

There are several good explanations on the internet of how this occurs, but one of the first and best was given by Tristan Yates and Lye Kok, here.

Essentially, what is called the “constant leverage trap” forces the fund to buy high and sell low, a strategy that goes against common sense. The higher the volatility of the underlying market, the more likely that leveraged indices will lose ground, as well. Furthermore, there’s absolutely no way of telling, given a certain period return on the underlying index, what the leveraged, or inverse leveraged index’s return will be. What these derivative indices actually produce as a return is path-dependent; how you get to the end point is more important, in determining the final investment outcome, than what the start and end levels of the “base” index actually are.

Graf reminded the audience that the expected ultimate value of a leveraged index that rebalances daily or monthly is zero. And the higher the underlying market volatility, the sooner you eat up all your capital.

Essentially, holders of leveraged and leveraged index ETFs are the ultimate gamblers. While these funds can deliver outsize returns for investors who get their market timing right, they are still playing a form of Russian roulette.

Do investors realise this? The fact that leveraged and inverse leveraged ETFs represent 2% of the European ETF market by assets under management, but also three out of the top ten most-traded European ETFs, suggests that they are indeed seen more as a trading vehicle than a long-term holding.

Graf went beyond the demonstration of the risks inherent in the leveraged indices (those offering 2, -2 and higher multiples of the daily index return) and examined how the “simple” inverse (minus one times) version of the German DAX index had performed against the long DAX during times of market falls. During the 2008/9 market fall the ShortDax returned +70.7%, “outperforming” the inverse of the long DAX return, which was -59.9%. Again, the divergence is explained by the daily rebalancing performed on the inverse index version, and the path followed by the DAX during the year. During other historical bear market periods, the simple inverse gave a return more than compensating for the long index’s fall on some occasions, and slightly less on others.

Graf’s conclusion was that simple inverse funds have a valuable hedging role to perform in some accounts – for example, those that may be prevented from physical shorting, or from the use of futures. Equally, he argued, investors might develop strategies based on a trading rule of switching between the long and the inverse index version, for example at certain “trigger points”, such as levels of index volatility. Such trading strategies might be used with the leveraged index versions as well, albeit with higher risk.

Graf is preparing a paper for publication, based on his index research, which will prove a valuable addition to investors’ knowledge base.

So where next for ETFs based on inverse, leveraged, and inverse leveraged indices? There is clearly a potential hedging role for the simple inverse funds. And for leveraged funds, which met with a huge bout of investor enthusiasm at two or three years ago, but which have been under a big question mark as the result of poor 2008 performance, it looks as though new trading strategies are evolving.


More on this topic

(What's this?)

The Hidden Risks of ETFs




The Great FAS and FAZ Loss


Read more on
Exchange Traded Fund (ETF),
Leverage
at Wikinvest

 




Latest comments on this feature



Post a Comment


Comment

(Limit 2,000

characters) 

*
Name:
*
E-mail:
*
Home page:


(optional)

Type in the displayed characters:
Email follow-up comments to my e-mail address
 


The views expressed by Paul Amery, Jim Wiandt and Matt Hougan are for informational purposes only and should not be construed as a recommendation for any security.

[yasr_overall_rating size="large"]
error: Alert: Content is protected !!