Beware the lurking dangers of leveraged ETFs

John Kenchington

It was interesting to see BlackRock’s outspoken chief executive Larry Fink last week warning that leveraged ETFs could “blow up” the financial system one day.

BlackRock operates the massive iShares business, the biggest ETF issuer in the world, so its decision not to go along with the leveraging trend is striking.

Leveraged ETFs use complex derivative or debt structures to deliver greater returns than the markets they track. But there’s a crucial difference between the nature of the leverage on an ETF and that of, say, an investment trust, which may borrow money to buy up extra stocks and shares.

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On a leveraged ETF it’s the daily return of an index that is boosted, so if one day the FTSE 100 gains 1 per cent a triple-leveraged FTSE 100 ETF would gain 3 per cent that same day, or lose 3 per cent that day if the index fell.

Over time these gains or losses can mount significantly and the ETF’s performance can fail to even resemble the performance of the market being tracked.

I once wrote about the case of the ETF Securities Leveraged Natural Gas exchange traded commodity, which managed to lose 90 per cent of its value during an 18-month period where the price of gas itself stayed quite static overall. This was partly because investors were exposed to the commodity’s futures curve, not its spot price.

In a Reuters report on Mr Fink’s remarks was a line that claimed that leveraged ETFs were increasingly being promoted by financial advisers in the US as “buy-and-hold investments”.

I did a little more research and it seems to be a major issue.

The website of one civil law firm specifically recommends that potential clients get in touch if an adviser has recommended a leveraged ETF.

In May 2012 the US authorities fined a series of big investment banks millions for selling leveraged ETFs without explaining the risks and the SEC has warned about the products – but it has yet to clamp down on leveraged ETF sales by advisers.

Remarkably, just two months ago the Wall Street Journal reported two respected advice experts had published a paper arguing that 15 per cent of client portfolios should be placed in triple-leveraged ETFs.

Last week, IFA Alan Smith of Capital Asset Management, who only uses passive funds, told me it’s unlikely any UK adviser would ever recommend a leveraged ETF except for the most sophisticated clients.

Of course, US advisers aren’t regulated in the same way as in the UK – they are more like brokers or sellers of investments in many cases.

But it’s still striking what a buccaneering bunch they seem to be relative to the UK.