Products that blur the line between gambling and investing have recently found a mass audience.Nathan Denette/The Canadian Press
The humble index fund has an evil twin.
Think of it as an ETF with a goatee and an eyepatch. In this case, the dead giveaway is leverage.
While the plain-vanilla version of an exchange-traded fund offers broad stock market exposure with low fees, its lookalike uses borrowed money and derivatives to try to turbocharge returns.
Products that blur the line between gambling and investing are finding a mass audience. Leveraged ETFs are the fastest-growing category in Canada and have accumulated $12.2-billion in investor money as of the end of October, according to National Bank Capital Markets.
With the stock market in steady ascent, the retail investor base is increasingly enamoured with the big, fast returns that leveraged ETFs can deliver.
Ranking fixed income funds and ETFs for stability, income and total return
Those same products can inflict enormous losses on those who fail to understand them. When leverage is involved, ETFs can disconnect dramatically from the assets they are designed to track.
The reasons are rooted in complex math and something called “volatility decay,” but the end result is simple to see.
For example, Global X Investments offers a pair of leveraged ETFs tracking the natural gas market, one for bulls, that is designed to benefit when gas prices rise, and a bear version that should gain when prices fall.
The bear fund has declined by 35 per cent year to date, not that surprising considering natural gas prices are up on the year. But the bull fund is also down, by 47 per cent. Such is the topsy-turvy world of leveraged ETFs.
The distortions tend to be higher as more leverage is employed. The first single-stock ETFs introduced in Canada used modest leverage and might be appropriate for longer-term holds.
This year, the industry has been busy pushing the ETF into ever-riskier territory with products that are not meant to be held longer than a day or two.
The first double-leveraged leveraged funds built around single stocks arrived on the Canadian market in June, courtesy of LongPoint Asset Management.
Just this week, LongPoint launched an ETF designed to double the opposite daily return of Shopify Inc. If, for example, Shopify’s stock goes up by 5 per cent in one day, the ETF should drop by about 10 per cent.
“For the first time in Canadian ETF history, active investors can now utilize a double-leveraged inverse single-stock ETF linked to an actively traded Canadian equity,” LongPoint said in a news release.
Look for a future Canadian Heritage Minute to commemorate the milestone.
Triple-leveraged funds also recently made their debut in Canada. Some of them track subsectors, like Canadian gold miners or the big banks. LongPoint’s pair of U.S. semiconductor funds have seen giant moves since they began trading in May. The triple-leveraged bull fund is up by 147 per cent, its bearish counterpart down by 70 per cent.
There are no triple-leveraged single-stock ETFs trading in North America, at least not yet. But one small fund that traded in London illustrates their risks. Last month, investors in the GraniteShares 3x Short AMD Daily ETP were wiped out when shares in AMD rose by as much as 38 per cent intraday.
That was enough to take the fund down to zero in a single trading session.
Still, fund providers are trying to ratchet up the amount of leverage used even further. U.S. regulators are reportedly reviewing applications for dozens of five-times-leveraged funds that track stock market indexes, single stocks and cryptocurrencies.
“From the perspective of someone who’s been a lifelong fiduciary, it’s concerning to see irresponsible retail products getting rolled out with gusto, daily and weekly,” said Brian Madden, chief investment officer of First Avenue Investment Counsel.
Leveraged funds are gaining traction in Canada, as their assets under management have risen by 76 per cent so far this year. Most of that money is in lightly leveraged funds, but the industry is clearly trending toward bolder, riskier products.
Fund providers are upfront that most leveraged ETFs are short-term trading instruments, not buy-and-hold products.
“There are investors that these are probably not suitable for,” said Chris McHaney, head of investment management and strategy at Global X. “It’s incumbent on us and the financial industry in general to promote that educational component.”
Full credit to the ETF for popularizing low-cost index investing. Take caution as the industry drifts ever further from that mission.