What Are Leveraged ETFs?

Leveraged ETFs provide 2 or 3 times the daily return of the underlying investment. Therefore, in a 2× leveraged ETF, every $1 invested yields amplified returns of a $2 or $3 investment (less fees and costs) on both the upside or downside.

Leveraged exchange-traded funds offer the following features:

1. Leverage: Leveraged ETFs provide two or three times the daily return of an underlying index.

2. Margin with Low-Maintenance: The leverage facility is managed inside the exchange-traded fund’s structure. Investors do not need to borrow outright, deal with margin calls, or roll options.

3. Inverse Exposure: By buying Bear ETFs, investors can obtain inverse returns without opening a special brokerage account. All products are exchange-traded.

4. Potentially a more cost/tax effective way to short. Typical users may range from institutional traders to individual retail investors.

Leveraged or inverse leveraged ETFs may be used for four main reasons:

1. Hedging an existing long position using the inverse ETFs.

2. Taking a speculative outright position (long or short)

3. Alpha Generation

4. Long/short and “spread” trades

Consequences of Daily Rebalancing:

Re-balancing the leveraged ETF position will improve the time period tracking error. In spite of the market’s swift adoption of leveraged Bull and Bear ETF products, aspects of their methodology have come under scrutiny in domestic press and in online investor forums. The main critique is that investors’ expected returns over time may differ significantly from their actual payoff. For example, if the underlying index gains 10% over 1 year, this doesn’t mean that the 2× Bull ETF, which is rebalanced daily, will gain 20% over the same period.

Example: Invest $100 in the 2× Bull Index product.
Returns: Day 1: +10%, Day 2: -10%.

The investment value at the end of the period is not $100, but rather: $100 × [1 + (2 x 10%)] × [1 + (2 x -10%)] = $96.00, or a 4% loss.

The rule of thumb is that in a steadily trending market with low volatility, an ETF with daily rebalancing will outperform traditional. However, if daily returns are volatile, even if the underlying index’s overall performance is positive, the 2× bullish ETF will likely underperform.

The explanation is fairly straightforward, and it has to do with the daily leverage adjustments: whenever the index experiences a large daily decline, the fund sells assets and reduces its debt level to bring the leverage ratio back to 2. This locks in losses, making it harder to recover lost
gains when the market turns higher.

Mounir R. El-Ayari, CIM, FCSI, C.h. P. Strategic Wealth
Investment Advisor
Associate Portfolio Manager
e-mail: mounir.el-ayari@nbf.ca

There is currently a lot of conflicting opinions in regards to where global stock markets are headed over the next few months. On the one hand, we have the perpetual bears that strongly believe that the market is ripe for a sharp sell-off. David Rosenberg, the former Chief Economist art Merrill Lynch, for example, is adamant that the market will re-test their March lows. Others, however, believe that the worst is behind us and there is nothing but blue skies ahead. These conflicting views are causing retail investors a lot of confusion. My advice is to wait and be patient.

In my opinion, markets around the world have rallied far too quickly given where we are in the current economic cycle. History has shown that markets typically overshoot their fundamentals as news of an improved economy begins to emerge. I think this is what is happening now.

As the realities of the economic condition set in, stock markets will likely retreat in the coming summer months. It is during this period that investors should be diligent in patiently looking at the economic landscape and carefully picking their entry points into sectors that look most promising going forward. Patience often yields the best results when investing in stocks during uncertain times because it allows investors to make informed decisions with the help of their financial advisors rather than simply buying stocks because they have risen dramatically. I have always been a proponent of buying on weakness and selling into strength. If, for one reason or another, you missed buying on weakness then the best strategy t is to wait once again for the markets to weaken.

Mounir R. El-Ayari, CIM, FCSI, C.h. P. Strategic Wealth
Investment Advisor
Associate Portfolio Manager
e-mail: mounir.el-ayari@nbf.ca

I have been saying that it is unlikely that the global economy would experience a V-shaped recovery. A V-shaped recovery describes the shape of the market’s performance in a recession and subsequent recovery when graphed. Essentially, out of the various recovery scenarios a v-shape recovery is the most welcomed because the economy rebounds very quickly. Given the magnitude of the global economic crisis this scenario was unrealistic.

More recently, we started hearing about a “W-shaped” recovery. I am not exactly sure when this term was coined, but I have been arguing for months that the likely scenario for the global recovery will be one where the market will eventually rally, which it has, and then re-test its lows before the economy moves towards a period of extended growth. Now, I have a buzzword that I can use to describe what I have been saying for months.

Currently, we are at the mid-point of the recovery. Going forward I expect that global stock markets will retrench as investors realize that it may take more time for the easing initiatives of the world’s central banks to fully take hold. Investors are a precarious bunch. They tend to like their returns big and fast. This isn’t going to happen this time around. If, however, the markets do retrench and investors buy some high quality names they will do extremely well going forward. If, however, I am wrong and we do have a sharp recovery investors will be equally as happy because the worst will then be behind us.

Mounir R. El-Ayari, CIM, FCSI, C.h. P. Strategic Wealth
Investment Advisor
Associate Portfolio Manager
e-mail: mounir.el-ayari@nbf.ca

As an investor the most difficult decision to make is when to buy and when to sell. The recent rally has not made this decision any easier. Over the last several weeks, investors seemed to have changed their mindset from not wanting to own stocks under any circumstances to panicking because they are afraid that they are going to miss substantial gains on the upside. My advice to these investors is to stay calm. Investment decisions should never be made hastily.

In terms of the economy not much has changed from three weeks ago. The G20 Summit seems to have gone over well despite some bickering between the various countries in regards to how much stimulus is enough. The First Lady, Michelle Obama, was photographed in a genuine embrace with the Queen. And stocks around the world have rallied from their lows. In terms of the economic news, however, not much has changed. So what does all of this mean?

In my opinion, I believe the tone of the market has changed and it’s time for investors to make some long-term investment decisions. The Dow Jones Industrial index is still down 43% from its all-time high, so it has a long way to go before anyone should break out the champagne glasses. In terms of the recent rally the index is up 24% from its low. If you are losing sleep because you didn’t catch the very bottom you probably have unrealistic expectations in terms of your ability to time the market.

As a portfolio manager I am patiently waiting for the stock indices to pull back before making a commitment to buy because I prefer buying on days that stocks are under some selling pressure. I am not, however, going to buy stocks simply because they have risen. I will, however, be taking a little nibble if there is a reasonable pull-back because it would be unfortunate to not take advantage of current stock valuations.

Mounir R. El-Ayari, CIM, FCSI, C.h. P. Strategic Wealth
Investment Advisor
Associate Portfolio Manager
e-mail: mounir.el-ayari@nbf.ca