By Oliver Smith, portfolio manager at IG Group.

Oliver Smith, portfolio manager at IG.

In recent years the number of ETFs available on the London Stock Exchange has exploded, with sector, smart beta and actively managed ETFs taking their place alongside mainstream index trackers. But are they the most effective way for investors to get long and short exposure to markets?

Leveraged exchange-traded funds are designed to provide the daily return of an index which can be amplified by increasing or reducing their exposure to the underlying index using derivatives. Often known as bull or bear funds, the leveraged ETF will typically aim to achieve twice or three times (3x) the daily return or inverse return of the index.

This makes them more risky than non-leveraged ETFs. It’s also important to stress the daily return element, as they are not designed to be held for long periods of time, due to the effect of volatility on returns.

Using an extreme example, and comparing a normal index fund with a 3x leveraged fund, we can illustrate how this works. On day one if the index rose 10%, the 3x leveraged fund would gain 30%. However on day two, if the index fell back to 100 (a loss of 9.09%), the 3x leveraged fund would fall from 130 to 94.5, a loss over the two days of -5.5%. Normal market movements are of course much smaller than this, but the principal still holds and a loss of relative value will always occur if the underlying index changes direction from positive to negative.

In the graph below we chart a real world example, showing the share price of a daily 3x Leveraged FTSE 100 ETF against the FTSE 100 Total Return index. Since the launch of the ETF, the index gained 19% while the 3x leveraged ETF made 26%. It has outperformed the index, but certainly not by 3x the amount.

Source: IG Group.

Looking at the volatility of the returns, the index has a volatility of 14.8% while the ETF has a realised volatility of 44%, which is 3x higher and illustrates that it has performed as expected. However when looking at risk-adjusted performance (annual returns divided by volatility), a long-term holder would not have been sufficiently rewarded for the risk they had taken on.

As a general rule of thumb you can expect leveraged ETFs to perform better than you might expect in rising markets, and worse than you might expect in flat and falling markets. We can see this quite clearly in the chart, where the 3x leveraged ETF lost money in the year between June 2015 and June 2016 when the index trended sideways.

Leveraged ETFs for short-term holders definitely do hold some attractions as well as some drawbacks.

Leveraged ETF advantages include:

• They can be bought and sold through a share dealing platform
• They are traded like a stock, with intra-day liquidity, and several market makers will price each one
• They can amplify returns, but with the risk of higher losses if the market moves in the opposite direction
• You can get greater market exposure using less money
• You cannot lose more than your entire investment
• Short leveraged ETFs are designed to make money when the market is falling, and can be used to hedge existing positions
• Counterparty risk is mitigated by trading on exchange

Leveraged ETF disadvantages:

• They are more complex than regular ETFs, using derivatives to gain market exposure rather than holding the constituents of the underlying index
• Many of them are too small to be commercially viable
• Choice is largely restricted to mainstream equity indices, commodities and currency pairs
• Dealing spreads are usually wider than un-leveraged ETFs
• The ETFs can be quite illiquid and difficult to trade

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)