Leveraged and inverse ETFs are ‘like walking into a casino’
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The Foreign & Colonial Government Trust listed on the London stock exchange in 1868 with the explicit aim of allowing small investors to gain exposure to a diversified portfolio of government bonds.
Since then a variety of newer, glossier structures have emerged, from mutual funds to exchange traded funds, but the raison d’être remained the same: to provide a ready-made portfolio of securities to an investor almost irrespective of their means, allowing them to tap into “the only free lunch in investing” — diversification.
The point of a fund was that it should be lower risk and less volatile than its underlying securities. But a flurry of activity in a corner of the exchange traded fund world has turned that premise on its head.
There is currently $103bn invested in leveraged or inverse ETF worldwide, according to data from Morningstar Direct: em; $80bn in the US alone.
These funds provide investors with a means to speculate on up to five times the daily return of either a basket of securities or an individual security, such as Tesla, Airbnb or Ferrari, allowing investors access to funds that are intentionally riskier than individual securities.
Net flows to leveraged and inverse funds hit a record $28bn last year, equivalent to 3.7 per cent of all purchases of exchange traded products, comfortably erasing the previous high of $17.1bn and 2.3 per cent in 2020, Morningstar data show.
Yet overall investors have lost money. The funds have taken in a net $63.3bn since the start of 2017, but assets have only risen by $48.6bn over this period, even as global markets have risen.
Moreover, issuers of these leveraged and inverse funds freely admit they can only provide the promised return over a single trading day. Hold for any longer and the returns may well diverge from those stated on the tin. Worse still, the mathematics of “leverage decay” means these returns are more likely to be negative than positive the longer a product is held.
So not only has short-term gambling replaced long-term investing but, as in a casino, the odds are stacked against the gambler.
“There is no reason why an individual investor should be buying these,” said Kenneth Lamont, senior fund analyst for passive strategies at Morningstar. “They are very high risk. They are equivalent of walking into the casino and slapping down your chips on red — and that’s not investing any more.”
Illustrating the losses, ProShares UltraPro Short QQQ (SQQQ), a bet against the tech-heavy Nasdaq 100, has had net inflows of $11.4bn over the past decade, according to Morningstar, but currently has assets of just $4.8bn.
Similarly, Next Funds Nikkei 225 Double Inverse Index ETF (1357) has hoovered up $5.8bn, but investors have just $1.9bn to show for it.
Worse still, investors in the VelocityShares 3x Long Natural Gas ETN (UGAZ), saw $3bn of net inflows turn into $105mn of assets. There have, though, been some success stories: the $7bn of net inflows into ProShares UltraPro QQQ (TQQQ) has become $15.4bn of assets.
This illuminates a stark divide. Since the start of 2017, $36.1bn has been pumped into inverse equity ETFs in the US, while assets only rose by $9.6bn, pointing to huge value destruction. In contrast, $15.3bn sunk into leveraged long equity ETFs has coincided with a $37.8bn rise in assets, indicative of gains.
“There was a more than 10-year raging bull market and inverse funds are designed to go down when the market goes up,” said ProShares, which operates four of the five largest leveraged or inverse ETFs.
“For the last 10 years, leveraged equity funds generally produced significant gains and some were among the best performing funds. For example, TQQQ returned over 22 times its starting value during this period.”
But while leveraged and inverse ETFs might be useful to professional investors, there are concerns that they are so accessible to less sophisticated ones as well.
Back in 2020 a coalition of large ETF issuers, including BlackRock, Vanguard and State Street Global Advisors, called on US regulators to tighten product definitions, arguing that leveraged and inverse ETFs should be forced to rebrand as exchange traded instruments.
“There are investors out there who associated the ETF structure with something a bit more diversified and safer, and we are seeing products that can be damaging to investors but are wrapped up in the same structure,” Lamont said.
“There are some in the industry, more conservative players, that are a bit concerned, and at Morningstar we are also a bit concerned,” he added.
In Europe, these vehicles are already typically labelled as exchange traded products or notes, in order to comply with Ucits fund regulations. The European market for leveraged and inverse products has contracted since peaking in 2017, although net flows have remained positive.
Ed Egilinsky, managing director of Direxion, which manages $29bn in leveraged and inverse ETFs, played down the concerns, arguing that the products were expressly aimed at active traders, be they “financial professionals or very sophisticated retail investors”, who “want to express a short-term view as to whether the market is going up or down”.
“These are not the type of product that are buy and hold. They are not appropriate for everybody. What is important is education,” he added.
Egilinsky was confident that Direxion’s products were being used correctly, saying that the daily trading volume can often be 50-100 per cent of an ETF’s assets, indicative of short holding periods.
“Many of these products are being used as gambling tools. They are the direct equivalent of spread betting,” said Lamont.
“They can have hedging benefits, but I don’t think that’s how they are typically used. They are used to take risk. Some of these products are clearly not suitable for unsophisticated investors. They need to be protected.”