Leveraged exchange-traded funds (ETFs), which provide magnified exposure to different market indices, have provided everyday investors with powerful hedging and speculative trading instruments that were once the reserve of institutional investors.
These instruments typically provide two (2x) or three-times (3x) exposure – long or short – to a specific financial market index covering equities, bonds, commodities or currencies.
In Europe, the dedicated specialist in this space is Boost ETP, a London-based firm offering a range of three-times leveraged long and short exchange-traded products (ETPs) on equity and commodity indices. Other players active in the European market include ETF Securities, best known for its commodity and currency ETPs, db X-trackers, RBS, ComStage, Amundi, EasyETF, Lyxor, and Xact.
In the US, the leveraged and short ETF space is dominated by ProShares and Direxion, with iPath, PowerShares and FactorShares also throwing useful products into the mix. Globally, there is more than $40 billlion invested in these instruments.
The way these products work is relatively straightforward. The Boost Nasdaq 100 3x Short Daily ETP (QQQS), for example, seeks daily investment results that correspond to three times the inverse (-300%) of the daily performance of the Nasdaq 100 Index. This ETP provides investors with an effective short-term hedging tool for portfolios with significant long exposure to US technology stocks – the Nasdaq is seen as a proxy for US tech stocks.
The ETP could also be used as a speculative tool in order to express a high-conviction short-term negative view on the broader stock market, and more specifically tech stocks. To visualise this in action, consider the period from mid-September to mid-November last year when the Nasdaq-100 fell 11.9%, primarily as investors lost some faith in Apple. Had investors held QQQS during this period they would have reaped a trading gain in the region of 35.7% (before fees) – not bad for a two-month holding period! By the same token, however, investors in the Boost Nasdaq 100 3x Leverage Daily ETP (QQQ3) during this period would have stomached losses of approximately the same magnitude.
In the US, ProShares’ comparable ETFs, the ProShares UltraPro Short QQQ ETF (SQQQ) and ProShares UltraPro QQQ ETF (TQQQ), have proved highly popular with investors and traders alike. Other popular leveraged instruments stateside include the Direxion Daily Financial Bull 3X Shares ETF (FAS) and the Direxion Daily Financial Bear 3X Shares ETF (FAZ), which are linked to the performance of the Russell 1000 Financial Services Index. Investors use these instruments to speculate on the direction of large-cap financial stocks on an intra-day basis or hedge their exposure, either long or short, in financial stocks. As speculative trading tools, these ETFs generally do best during trending markets and extended moves. Leveraged financials ETFs such as these have been particularly popular in recent years as the sub-prime mortgage fiasco and then the European sovereign debt crisis roiled global markets.
Another segment of leveraged ETFs coming into their own are those that provide inverse exposure to government bonds such as US Treasuries and UK Gilts. Examples include the ProShares UltraPro Short 20+ Year Treasury ETF (TTT) in the US and the db X-trackers UK Gilts Double Short Daily UCITS ETF (XUSS) in the UK. These products can help investors reduce the duration of their bond portfolios and better protect them against potential rises in interest rates, without necessarily giving up the yield compensation associated with the assumption of credit risk.
While there can be drawbacks to investing in these instruments (such as thin volumes, leverage decay [owing to swap resets/rebalancing] and, of course, the potential for amplified losses), leveraged ETPs provide investors with an effective piece of kit to further enhance their investment toolbox – whether for aggressive or defensive purposes.