Monday, January 28, 2008

Swinging to a New Strategy

Many Canadians are playing the markets like never before thanks to a fast-growing class of leveraged exchange-traded funds

ALEX ROSLIN
SPECIAL TO THE GAZETTE
Monday, January 28, 2008
The Montreal Gazette

As markets yo-yo crazily up and down, growing numbers of Canadians are turning to a risky new investment strategy that used to be the preserve of professional speculators and big investment firms: leverage.

Ordinary investors can now play market swings like never before thanks to a fast-growing class of leveraged exchange-traded funds.

ETFs are like mutual funds that trade as stocks on an exchange. They seek to match the moves of an underlying market like the S&P/TSX composite index or gold. Unlike mutual funds, they are passively managed and charge minimal management fees.

The universe of ETFs has exploded in recent years in Canada and the U.S. as mutual funds have come under fire for exorbitant fees and lackluster returns.

The new leveraged ETFs offer yet another choice. They promise to double the gain-and-loss of the underlying market.

In other words, if the S&P/TSX 60 Index goes up $1, the related ETF aims to rise $2.

Confused? Here’s yet another twist: some of the new leveraged ETFs seek to double the inverse of an underlying market. So when the TSX 60 drops $1, the ETF goes up $2.

Horizons BetaPro, the Toronto-based financial-products company that is the only provider of leveraged ETFs in Canada so far, launched four new leveraged ETFs last Wednesday covering gold bullion and global mining stocks.

The company’s Gold Bullion Bull Plus ETF (symbol HBU) uses gold futures contracts to achieve two times the change in the price of gold.

Meanwhile, its Gold Bullion Bear Plus ETF (HBD) seeks to do the opposite—double the inverse of moves in the gold price.

Earlier in January, BetaPro launched new leveraged ETFs covering the price of crude oil and natural gas. And the company plans to kick off two more funds in early February for a basket of agricultural commodities—soybeans, wheat and corn.

The new products will bring the company’s leveraged ETF offerings to 18.

As the only leveraged commodity ETFs in the world, the products are drawing interest internationally, with assets in the company’s funds growing more than fivefold to $750 million in 2007, said president Howard Atkinson.

Horizons BetaPro offers still other leveraged vehicles in its family of mutual funds, including ones that seek to double changes in Canadian bond prices, the NASDAQ-100 Index and the U.S. dollar.

The company has hired ProShares Trust, which has launched several dozen leveraged ETFs of its own in the U.S., as the portfolio manager for its ETFs.

“Since 1999 to 2000, we’ve seen some good (market) upswings, but also good old-fashioned bear markets. In those environments, which we seem to be in now, our product can be quite useful,” he said.

But just how practical are leveraged funds for ordinary folks? Analysts have mixed feelings.

“For most investors, they’re not worthwhile,” said David O’Leary, manager of fund analysis at Morningstar Canada, a leading investment-research firm that rates ETFs and mutual funds.

“They’re very tough to own. They tend to be extremely volatile so it’s harder to stay along for the ride. What we see time and again (with these funds) is people buying high and selling low. People tend to get more greedy and excited.”

They’re more suitable, he said, for “fairly knowledgeable investors trying to play a trend.”

Jeffrey Ptak, Morningstar’s director of exchange-traded securities analysis in Chicago, agreed. In early January, he wrote a report on the worst new ETFs of 2007. One of his top picks: leveraged ETFs.

“In my opinion, they are a terrific way to blow an investor up,” he said in an interview. “For long-term investors, they have tenuous value from a risk-reward standpoint.”

Ptak’s main concern: most of the time, the ETFs haven’t actually succeeded in doubling the return of the underlying market.

For example, since it started trading on Jan. 10, 2007, BetaPro’s 60 Bull Plus ETF (symbol HXU) gained 18.5 per cent in the subsequent year. That’s 58 percent more than was gained by the unleveraged iShares Canadian S&P/TSX 60 Index Fund, which went up 11.7 per cent over the same period.

A great return, but not double.

On the other hand, BetaPro’s Energy Bull Plus ETF (HEU) lost 59.6 per cent between its launch in June and last Wednesday, while the iShares Canadian S&P/TSX Capped Energy Index Fund (XEG) lost 23.8 per cent.

That works out to a loss 150 per cent greater for HEU than XEG—more than double.

So in that case, a savvy investor might wonder, did BetaPro’s leveraged inverse energy fund (HED) make a killing? Ironically, no.

HED did gain a tidy 40.9 percent since last June. But that’s 72 per cent more than what was lost by XEG—again, short of 100 per cent.

Atkinson, Horizons BetaPro’s president, said the shortfalls arise from the mysteries of compounding and volatility. On a daily basis, he said leveraged ETFs are, indeed, able to exactly double the underlying index.

But results are less predictable over longer periods. When markets are zigzagging up and down, for example, leveraged ETFs tend to achieve less than a doubled return.

Conversely, when a market is in a longer trend, a leveraged ETF can actually more than double the underlying index.

Atkinson said investors can get around this conundrum by regularly rebalancing their holdings. Rebalancing is especially recommended in more volatile markets if an investor wants to be sure to achieve a doubled return, he said.

Horizons BetaPro offers a tool on its website to help investors figure out how much rebalancing is needed based on their holdings.

Don Vialoux, an Oakville, Ont.-based market analyst and author of the DVTechTalk.com website, said leveraged ETFs are ideally suited for shorter-term traders seeking to play a market trend.

But they can also be useful to hedge a long-term portfolio when markets take a tumble, he said.

“If you’d used that strategy over the past two weeks, you would be a happy camper.”

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