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Tuesday, November 10, 2009
Leaders On Nasdaq, TSX TSX-V
ETF Investing Or Gambling?
Mark Yamada
Published on Monday, Nov. 09, 2009 6:22PM EST Last updated on Tuesday, Nov. 10, 2009 6:04AM EST
Mark Yamada is CEO of PUR Investing, a Toronto-based portfolio manager that uses exchange-traded funds.
Canadian investors may be the most mistreated on the planet, so they should not be surprised if leveraged and inverse exchange-traded funds were deliberately designed to dupe and mislead them. Such is the rhetoric of investor protection groups.
The highest volatility in 80 years distorted returns for leveraged ETFs, or 2xETFs, that aim to double the daily return of an underlying index for bull versions or double the inverse for bear versions.
These ETFs have attracted much criticism; their use has been curtailed by some and banned by others. Self-regulating organizations, FINRA (U.S.) and IIROC (Canada) stated: “Inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”
“Unsuitable” means brokers can't use them for clients beyond a single trading day. But would investors be positively or negatively impacted by holding these ETFs for periods longer than one day in different markets with different volatilities?
Mind-Blowing Results
The gripe is that 2xETFs did not do what some investors expected last year. This table shows how 2xETFs fared against the S&P/TSX Capped Energy Index for the year ended September 30, 2009. Making the right call (falling index) cost almost as much as making the wrong call, and both cost a bundle.
| Year ending September 30, 2009 | |
| S&P/TSX Capped Energy Index | -8.3 per cent |
| HBP Capped Energy Bull Plus ETF | -41.8 per cent |
| HBP Capped Energy Bear Plus ETF | -66.4 per cent |
To be clear, these ETFs delivered pretty much what they promised, two times the daily return of the underlying index. Translating daily returns to compounded returns during periods of high volatility involves volatility drag; higher volatility means higher drag.
Volatility drag is the impact that wide price fluctuations have on the difference between simple and compounded returns. If an index or security drops 10 per cent, it has only to gain 11.11 per cent to get back to even. If it falls 50 per cent in price, it has to double to get back to even. The difference is the result of volatility drag.
Professionals understand this, but retail investors and many of their investment advisers (formerly called stockbrokers) may not.
Crying “foul”, the Canadian Foundation for the Advancement of Investor Rights (FAIR), an investment-industry-funded non-profit organization representing the interests of Canadian investors in securities regulations, called for better disclosure in prospectuses and “point-of-sale” materials. The irony is that most investors don't read prospectuses and the characteristics of leveraged ETFs are already disclosed.
Volatility Gone Wild
Off-the-scale volatility in 2008-09, created drag that destroyed these ETFs' returns. We can thank FAIR, FINRA and IIROC for bringing attention to the issue, but there is another side to this story.
Over a different period, the HBP Financial Bull Plus ETF rose 86.9 per cent (more than twice the index) and the HBP Financial Bear Plus fell 69.3 per cent (less than twice the index). These are very different results. Upside gains were enhanced and losses mitigated. Investors win!
| YTD September 30, 2009 | |
| S&P TSX Capped Financial Index | 41.4 per cent |
| Horizon Beta Pro Capped Financial Bull Plus ETF | 86.9 per cent |
| Horizon Beta Pro Capped Financial Bear Plus ETF | -69.3 per cent |
Over different periods, and for holdings in excess of one day, 2xETFs can offer attractive results. Many critics assume the same level of volatility drag exists all the time and is always negative. This is simply not true.
Hypothetical one-year S&P 500 volatility “drag”, calculated daily from 1950 to September 2009, is shown below.
The number of “positive” drag days about equalled “negative” days, but there were far more positive spikes benefiting investors (+10 per cent) than negative spikes (-10 per cent). Holding periods are one year.
So why do FINRA, IIROC and FAIR want to limit activity to day trades? Could it be that:
- capital markets were so devastated that somebody had to take the blame?
- these organizations don't really understand the products and think they are evil?
- they understand the products but don't trust stockbrokers to use them properly?
The last reason would be understandable, either of the first two, disappointing. Leveraged ETFs allow individual investors to gain more efficient risk exposure while deploying less capital. Sophisticated institutions have been doing this for years but individuals, dealing through advisors, are constrained.
When Canadian investors are subjected to oligopoly bank pricing and the highest mutual fund fees in the world, should watchdogs focus on retail investors with $1-billion in assets (non-institutional, non-adviser-based) or on mutual fund holders with $583-billion, neither of whom read prospectuses?
Volatility drag would have favoured leveraged ETF investors by a significant margin from 1950 to date. A failure to consider this will inadvertently penalize investors.
Let's be fair, responsible criticism of any product should balance problems, like 2008-2009, with possible outcomes in different markets and time periods. Regrettably, this was not done for leveraged ETFs. To benefit from 2xETFs, Canadian investors must now educate themselves, something we and FAIR both support. Maybe this is a good outcome from a perhaps unfair, but certainly unbalanced attack.
Gold, loonie soars on plunging greenback
John Morrissy, Financial Post
OTTAWA - Gold, oil and the Canadian dollar shot out of the gate Monday as the plunging U.S. dollar and the prospect of continuing low interest rates sent investors searching for high-return assets.
"Money is fleeing the U.S.," said commodity analyst Dennis Gartman.
"Capital is concerned about rising inflationary pressures that emanate from both the changes in Washington and the Federal Reserve policies, and money is simply finding its way away from the U.S. dollar. That's been beneficial to gold."
Gold punched to new historic highs, breaching the $1,100 mark to trade up $5.70 to US$1,101.40 an ounce.
The Canadian dollar soared 1.57 cents to 94.57 cents US, while oil gained $2 a barrel to trade at US$79.43 a barrel.
Meanwhile, the U.S. greenback was off more than a full percent from its Friday close, as measured by the U.S. dollar index, which measures the greenback against a basket of six major world currencies. It has plunged almost 16% since early March.
Market watchers credited the move to comments made at the G20 meeting over the weekend in Scotland, at which finance ministers and central bankers said the world is still too dependent on low interest rates and stimulus dollars to pull the plug on those economic life supports.
Shaun Osborne, chief currency strategist at TD Securities, said high U.S. unemployment - climbing Friday above 10% for the first time since 1983 - also brought investors back to the "risk" trades of stocks, commodities and currencies.
"With the unemployment rate will pushing higher . . . it's going to be a very long time before the Fed (U.S. Federal Reserve) can think about tightening monetary policies. So that's encouraging from a risk point of view."
A plunging U.S. dollar, however, is less encouraging for Canadian manufacturers and exporters who must cope with the resulting high Canadian dollar, and for Bank of Canada governor Mark Carney, who recently made several speeches trying to talk down the loonie.
There's little Mr. Carney can do, Mr. Osborne said.
"They are not going to come in and intervene directly in the currency markets. It's potentially very expensive, there's no guarantee of success, and it's an unwinnable battle for the Bank of Canada to act in isolation against a generally weak U.S. dollar trend.
"The currency may be stronger than the bank would prefer, but we still think that fundamentally the Canadian dollar is not overvalued."
The commodity-laced Toronto Stock Exchange joined in the party on Monday - as did stock markets around the world - advancing 236.46 points, to 11,486.88, less than 100 points off its Sept. 22 year high of 11,585.73.
Despite the fact that markets have soared 60% since March, there's still room to go higher, said BMO Capital Markets economist Robert Kavcic.
"This is by far the best spot in the economic cycle for equities - when you go from recession to recovery.
"Similarly, when you're looking at changes in Fed interest rates, the best part of the cycle for equity markets is when the Fed is on hold and in the first third of the tightening cycle.
"If the recovery continues to play out as forecast, stocks should grind higher still."
"Money is fleeing the U.S.," said commodity analyst Dennis Gartman.
"Capital is concerned about rising inflationary pressures that emanate from both the changes in Washington and the Federal Reserve policies, and money is simply finding its way away from the U.S. dollar. That's been beneficial to gold."
Gold punched to new historic highs, breaching the $1,100 mark to trade up $5.70 to US$1,101.40 an ounce.
The Canadian dollar soared 1.57 cents to 94.57 cents US, while oil gained $2 a barrel to trade at US$79.43 a barrel.
Meanwhile, the U.S. greenback was off more than a full percent from its Friday close, as measured by the U.S. dollar index, which measures the greenback against a basket of six major world currencies. It has plunged almost 16% since early March.
Market watchers credited the move to comments made at the G20 meeting over the weekend in Scotland, at which finance ministers and central bankers said the world is still too dependent on low interest rates and stimulus dollars to pull the plug on those economic life supports.
Shaun Osborne, chief currency strategist at TD Securities, said high U.S. unemployment - climbing Friday above 10% for the first time since 1983 - also brought investors back to the "risk" trades of stocks, commodities and currencies.
"With the unemployment rate will pushing higher . . . it's going to be a very long time before the Fed (U.S. Federal Reserve) can think about tightening monetary policies. So that's encouraging from a risk point of view."
A plunging U.S. dollar, however, is less encouraging for Canadian manufacturers and exporters who must cope with the resulting high Canadian dollar, and for Bank of Canada governor Mark Carney, who recently made several speeches trying to talk down the loonie.
There's little Mr. Carney can do, Mr. Osborne said.
"They are not going to come in and intervene directly in the currency markets. It's potentially very expensive, there's no guarantee of success, and it's an unwinnable battle for the Bank of Canada to act in isolation against a generally weak U.S. dollar trend.
"The currency may be stronger than the bank would prefer, but we still think that fundamentally the Canadian dollar is not overvalued."
The commodity-laced Toronto Stock Exchange joined in the party on Monday - as did stock markets around the world - advancing 236.46 points, to 11,486.88, less than 100 points off its Sept. 22 year high of 11,585.73.
Despite the fact that markets have soared 60% since March, there's still room to go higher, said BMO Capital Markets economist Robert Kavcic.
"This is by far the best spot in the economic cycle for equities - when you go from recession to recovery.
"Similarly, when you're looking at changes in Fed interest rates, the best part of the cycle for equity markets is when the Fed is on hold and in the first third of the tightening cycle.
"If the recovery continues to play out as forecast, stocks should grind higher still."
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