Private Client Investing

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1 Private Client Investing Special Report Exchange-Traded Funds Leveraged, Inverse Leveraged, & Commodity ETFs: Benefits And Pitfalls ALFRED LEE, CFA, DMS Exchange-Traded Funds Private Client Investing See back page for state/provincial restrictions. All prices quoted in this report are as of the close of markets on May 6, Over the past five years, exchange-traded funds (ETFs) have achieved tremendous investor popularity. As such, the range of ETF product offerings has quickly expanded. Originally designed to match the performance of broad market indices, ETFs soon began tracking sectors, country-specific indices, currencies and even commodities. While all these products have been successful in catching the attention of the investing public, by far the most popular new ETFs over the past year have been leveraged and inverse-leveraged ETFs. Leveraged ETFs provide investors with exposure to double (or even triple) the daily return of their underlying index, or in the case of inverse-leveraged ETFs, double (triple) the inverse return of the underlying index. In the volatile market we witnessed last year, these investment tools quickly became popular with traders and hedge funds wishing to play either side of the market with extra horsepower. The added benefit of leveraged ETFs is that they don t expose the investor to margin calls and the maximum risk is the capital put forth. Despite the inherent appeal of some of these newer leveraged and commodity-based products, the use of derivatives to achieve their objectives can cause unintended consequences that should be understood before investors take the leap into this brave new world of ETFs. Under certain conditions, these ETFs can significantly underperform investors expectations. The Birth Of A New Breed After a three-year review by the U.S. Securities and Exchange Commisssion (SEC), ProShares introduced Growth Of Leveraged And Inverse Leveraged ETFs 300 Cummulative Number Of Leveraged its initial suite of leveraged 250 and Inverse Leveraged ETFs and inverse-leveraged ETFs to the world in The products became very popular and new leveraged ETF providers quickly 100 sprouted up in hopes of 50 sharing in the success. Rydex Investments, which 0 pioneered leveraged and * inverse-leveraged mutual funds, soon offered their *Year to date as of May 1, Source: Bloomberg own suite of leveraged and inverse-leveraged ETFs and as time went on, the selection of this new breed of ETFs quickly became more diverse., Canada s sole provider of these products, became the first in the world to offer leveraged and inverse-leveraged ETFs that track commodities, such as gold, oil and natural gas. Last year, newcomer Direxion Funds took leverage to a new level, introducing its suite of triple-leveraged and triple inverse-leveraged funds. Prior to their first day of trading, many doubted whether these ETFs would gain traction. However, within a little over a week three of the eight original Direxion ETFs were trading well over a million units a day. Today, Direxion s Financial Bull 3x ETF (FAS) has an average daily volume of over 200 million units. CIBC Wood Gundy is a division of CIBC World Markets Inc., P.O. Box 500, 161 Bay Street, Toronto, Canada M5J 2S8 (416)

2 Look Before You Leap Through the use of forward and swap contracts, leveraged ETFs are designed to capture double (or triple) the daily return of the index or commodity they track and inverse-leveraged ETFs capture double (triple) the inverse daily return of the underlying security. Therefore, when the underlying apprieciates 1% on the day, the leveraged ETF is supposed to appreciate 2% (3%) on the day and the inverse-leveraged ETF should depreciate 2% (3%) on the day. A common misconception about leveraged ETFs is that over the long-term they will deliver double (triple) the returns of the underlying. This is not the case, nor is this what they were designed for. In fact, over the long-term, the leverage factor could be significantly different from 2x (3x). There are a number of reasons which contribute to this, which we discuss below. Reason #1: The Power Of Compounding Because leveraged ETFs are designed to track the daily return of the underlying, the ETF must mark-to-market at the end of the trading day. Essentially, this means that when markets close for the day, these ETFs must be reset and recalibrated for the next day. For example, using fictitious numbers and not taking into consideration other factors such as management fees, suppose a double-leveraged ETF that is designed to track oil is trading at $100, while crude oil is also trading at $100. Therefore, each unit of this ETF acquired at $100 represents the equivalent of $200 invested in crude oil. At the end of the day, if the price of oil rises 5% to close at $105 per barrel, the ETF should be valued at $110 (($200 x 5%) + $100). The ETF is then reset after the close to represent $220 invested in oil for the next trading day. Compounding And Negative Compounding $1,200 $1,000 $800 $600 $400 $200 $- Compounding Growth (5%) Constant Growth (5%) Compounding Negative Growth (-5%) Period Source: CIBC Wood Gundy If the price of oil were to increase by another 5% the next day (to $110.25), the price of the ETF would rise another 10% to $121 (($220 x 5%) + $110). Thus, even though oil rose 10.25% over the two-day period, the ETF gained 21% (not the 20.5% one might have expected by simply doubling oil s return). The ETF has more than 2x leverage over the holding period as the first day s gains would be also be doubled. Much like interest in a savings account, the power of compounding in leveraged ETFs is very powerful over time. In contrast, if we assume the price of oil were to fall 5% on the first trading day, the ETF would close the day at $90 ((200 x -5%) + $100)). After five consucutive days of -5% returns, the price of oil would have fallen 22.6%, while the ETF would have fallen 41.0% (not 45.2%). Unlike the examples we ve given, in the real world investments never move up or down in a perfectly straight line. The returns on ETFs are very path dependent ; that is, the pattern, not just the direction, of the moves in the underlying security impacts the returns on the ETF. While the performance of the underlying security is important, nearly as important is how it got there. As a general rule, the longer the holding period, the more path-dependent the returns become. The complications of compounding and path dependency mean that it is possible that the ETF could have a negative return, even if the underlying security rose during the holding period. When the price of an ETF falls, it needs more of a gain the following day to make up for that loss, this is due to what is called negative gamma. See the table below for an example of this. Also, as day-to-day volatility increases (in contrast to moving steadily in one direction), the benefits from leverage appear to diminish. Example: Oil Price Rises, ETF Price Falls Value Cummulative Return Day Underlying ETF Underlying ETF 0 $50.00 $ $47.50 $ % % 2 $45.13 $ % % 3 $49.64 $ % -2.80% 4 $44.68 $ % % 5 $50.50 $ % -2.00% Source: CIBC Wood Gundy Investors who use inverse-leveraged ETFs to hedge a portfolio, may want to keep in mind that the number of ETF units required to keep their intended hedge will be dynamic. Because the rate of change on the ETF and portfolio value will not be equal, the hedge ratio, or what is referred to as the delta, will change over time. Therefore the hedge on a portfolio will be more efficient the more often the hedge ratio is rebalanced, however this results in cost of increased trading fees. Horizon BetaPro has a tool on its website to help determine the number of ETF units required to maintain the intial hedge or leverage ratio. Reason #2: Two To Contango While some commodity ETFs actually hold the commodity, other such ETFs use futures contracts (which are promises to deliver the commodity at predetermined dates in the future) in an attempt to replicate the returns of the underlying commodity. For those ETFs that use futures contracts, a significant portion of their return depends not on the return of the underlying commodity, but on the shape and slope of the 2 Special Report

3 underlying futures curve. This often leads the ETF to perform differently than the spot (or cash) price for the commodity. When the longer term futures contracts are trading at higher prices than both the existing spot price and shorter term contracts, the futures curve is said to be in contango. In this scenario, if the spot price falls or stays flat, the price for the futures contract will decline as the delivery date approaches until it is roughly equal to the spot price on the last day of the futures contract. Thus, even though the spot price didn t fall, the ETF s value does, because it was holding the futures contract, which fell in price. For the ETF to make a profit when the futures curve is in contango, the spot price must not only rise, but it must rise above the initial price of the futures contract. Even still, commodity ETFs will likely always underperform the spot price when the futures curve is in contango. The problem is exacerbated each time the underlying futures contract nears its expiry date and the ETF must sell the contract in order to purchase a longer-dated futures contract that is priced at a premium to the spot price. However, it is important to note that the ETF should outperform the commodity when the futures curve is in backwardation, which is when futures contracts are priced below the spot price. This issue applies to all ETFs that use futures contracts, not just leveraged and inverse-leveraged ETFs. Example - Contago Spot price on January 14: $100 Price for contract expiring February 15: $115 (a 15% premium to the spot price) Price for contract expiring March 15: $130 (a 30% premium to the spot price) Assume that after one month, on February 14, the spot price is 10% higher at $110 and that the futures premiums charged for one- and two-month contracts are still 15% and 30%, respectively. After one month, on February 14, the original one-month contract is set to expire, so its price will converge with the spot price, which is now $110. Hence, the spot price appreciated 10% to $110 but a $115 investment in the original one-month contract has fallen 4.3% to $110. The March contract now only has one month until it expires, thus is now a one-month contract. Assuming the one-month contract s premium to the spot price remains at 15%, the contract would be valued at $ To maintain its exposure to the commodity, the ETF must now sell its February contracts (for $110 each, or a $5 loss) and use the proceeds to buy the higher priced March contracts ($ each) and the process repeats itself. This is known as a negative roll yield and will exist so long as the futures market is in contango. Note, however, that the expiring contract won t always be sold at a loss. If the spot price rises above the price originally paid for the contract, then the investment will be profitable, although less profitable than if one held the actual commodity. Backwardation And Contango WTI Crude Oil Futures ($US/bbl) $130 $100 $70 $40 Source: CIBC Wood Gundy Contango Backwardation 1M 2M 3M 4M 5M 6M 7M 8M 9M Y Time Until Expiration Reason #3: Roll Dates To further complicate the roll yield issue, some ETFs begin to roll into the next contracts before the expiry date. Futures contracts can be quite volatile in the days before expiry; as a result, the media, which generally reference the near-month contract and not the actual spot price, will often report that the commodity has risen or fallen sharply in the last few days of a contract. Investors hearing this may expect the ETF to move similiarly, but the ETF may no longer hold that particular contract. Most commodity-related ETFs will indicate their next scheduled roll date on their websites. This issue applies to all ETFs that use futures contracts, not just leveraged and inverse leveraged ETFs. Reason #4: Holidays The stock exchange and the futures exchange may have different holiday schedules. As a result there will be days when the stock exchange is open, but the futures market is not. On these days, the trading of the ETF is driven by true market forces, meaning that it does not track the underlying futures on these days. Instead ETFs prices on these certain days are driven by the bid and ask of the market and will not be rebalanced at the end of the day. When the futures market opens for trading the next day, the price of the ETF will trade to match the move in oil over the two days. This issue, however, only impacts investors if they are buying or selling the ETF on days when the futures markets are closed. It should not affect performance over the long term. Reason #5: Currency Currency fluctuations may also impact an ETF s return. An ETF could track a foreign market index or commodity which is priced in a different currency than which the ETF is priced in. Thus, while the price of the foreign index may rise 5%, if the currency in which the ETF is priced in falls 5%, the price of the ETF may not change. Some leveraged and inverse-leveraged ETFs are currency hedged, however, and thus will not be affected by this factor. 3 Special Report

4 Reason #6: Management Fees Just as with mutual funds and other ETFs, management fees reduce the returns on the funds. Management fees for commodity and leveraged ETFs range from 0.5% to 1.6% per year. Thus, over short investment periods this is not a big factor. A Real Life Example To demonstrate the impact of some of these factors, we compared the performance of the Crude Oil Bull ETF (HOU) to the returns one might have expected by simply doubling the daily returns of the near-month oil futures contract. We broke our comparison into two time intervals: from January 16, 2008 to May 20, 2008, when the futures curve was in slight backwardation; and between January 15, 2009 and March 31, 2009, when the futures curve was in a steep contango. Performance During Backwardation Jan-08 Source: Bloomberg 2x Nearby Oil Futures Contract Crude Oil Bull Plus (HOU) Feb-08 During the first period, when the oil futures curve was in slight backwardation, oil prices advanced from US$90.84 per barrel on January 16, 2008 to US$ per barrel on May 20, 2008, a gain of 42.1%. Excluding all other factors, if the ETF were to experience double the daily returns of oil, it would have delivered a gain of 94.8% over the period. However, HOU actually delivered a return of 102.1%. The outperformance was partially due to a positive roll yield; a profit was made simply by rolling over to new contracts when the futures curve was in backwardation. During this period HOU had a correlation of 0.99 with the near-term oil futures, which is a near perfect positive correlation. A correlation of 1.00 would indicate a perfect positive correlation, which would imply that every time the price of one asset rises, the other will as well. (The Horizon BetaPro Crude Oil Bear Plus ETF (HOD), which is inverse leveraged so that if oil prices fall 1% on the day the ETF gains 2%, also held a very high negative correlation. During this time frame HOD had a correlation, which indicates a very strong inverse relationship.) Because of the roll yield factor and the tight correlation between oil prices and HOU during this period of backwardation, the returns on HOU were enhanced. However, because HOU does not have a long history (it was launched in mid-january of 2008), we have not yet seen HOU Mar-08 Apr-08 May-08 trade in a time of a steep backwardation. But in such a scenario, one would expect it to outperform oil to a greater degree. Correlation Matrix During Backwardation Nearby Oil Futures Contract Price Crude Oil Bull Plus ETF (HOU) Crude Oil Bear Plus ETF (HOD) Nearby Oil Futures Contract Price Crude Oil Bull Plus ETF (HOU) Crude Oil Bear Plus ETF (HOD) January 16 to May 20, Source: CIBC Wood Gundy In the second period we measured, between January 15 and March 31, 2009, the oil futures curve was upward sloping and was thus in contango. In fact, during this period, the market expected oil prices to climb much higher, and thus the futures curve was not only in contango but in a very steep contango. Performance During Contango Jan-09 Source: Bloomberg As one should now expect, the return on the HOU was below double the daily performance of the nearby oil futures price. However the amount of the underperformance is quite stark. While the futures rose 8.6% to US$49.66, HOU actually fell an astonishing 34.0% to $6.16 by the end of the period. Because of the negative roll yield factor, the correlation between the oil futures and the price of the ETF declined to However, the inverse-leveraged ETF, Horizon Crude Oil Bear Plus ETF (HOD), still held a very strong negative correlation to oil prices. Correlation Matrix During Contango Nearby Oil Futures Contract Price Crude Oil Bull Plus ETF (HOU) Crude Oil Bear Plus ETF (HOD) 2x Nearby Oil Futures Contract Crude Oil Bull Plus (HOU) Nearby Oil Futures Contract Price Feb-09 Crude Oil Bull Plus ETF (HOU) Crude Oil Bear Plus ETF (HOD) January 15 to March 31, Source: CIBC Wood Gundy Mar-09 4 Special Report

5 Proceed With Caution Commodity, leveraged and inverse-leveraged ETFs are innovative products that may have a place in a portfolio when used strategically. They can provide an investor with leverage without having to deal directly with the complications of expiry dates or margin calls that exist with derivatives. But investors must keep in mind that these ETFs do invest in derivatives and hence they should be viewed as hybrids between derivatives and equities. Thus these ETFs have many more complexities than the standard stock index ETFs, which have a structure that has been around for more than a decade. An investor should be well aware of the mechanics of these newer ETFs before making an investment. Over short periods of time, commodity, leveraged and inverse-leveraged ETFs can be effective investments under the right conditions. However, the ETFs can significantly underperform one s expectations during periods of steep contango in the futures markets, when the underlying security is volatile on a day-to-day basis, or when the currency of the underlying security is moving in the opposite direction than one would like. 5 Special Report

6 Glossary Backwardation: When longer term futures contracts are priced lower than the nearer term contracts. Backwardation suggests traders expect the price of the underlying asset/commodity to decline over time. [This is said to occur due to the convenience yield being higher than the prevailing risk free rate. Backwardation is the opposite of contango. Commodity: Something for which there is demand, but which is supplied without qualitative differentiation across a market. It is a product that is the same no matter who produces it, such as petroleum, soybeans, or gold. In other words, copper is copper. Rice is rice. Stereos, on the other hand, have many different levels of quality. The price of a commodity is relatively consistent across different markets. Contango: When longer term futures contracts are priced above nearer term contracts. Contango suggests traders expect the price of the underlying asset or commodity to rise over time. Contango is the opposite of backwardation. Convenience Yield: The benefit or premium associated with holding an underlying product or physical good, rather than the contract or derivative product. Correlation: The strength and direction of a linear relationship between two random variables. A correlation can be between -1.0 and A correlation of +1.0 between two random assets would indicate that when one moves up or down, the other will move in the same direction. The closer the correlation is to +1.0, the closer the relationship. A correlation of -1.0 on the other hand indicates that when one moves up or down, the other asset will move in the opposite direction. The closer the correlation to -1.0, the stronger this relationship will be. Hence if the correlation between two assets is 0.0, it would imply no relation at all. Delivery Date: All futures and forward contracts have a delivery date upon which the underlying security or commodity must be transferred to the contract holder if the contract is held until maturity. Delta: The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. Delta is also referred to as the hedge ratio. Derivative: A financial contract or instrument, whose value is derived from the value of an underlying asset or index. Expiration Date: The day on which the derivative (options or futures) contract is no longer valid and, therefore, ceases to exist. Forward Contract: A cash market transaction in which delivery of the commodity is deferred until a predetermined future date. Although the delivery is made in the future, the price is determined on the initial trade date. Unlike future contracts, forwards are not standardized nor traded on an exchange; forward contracts are customized to meet the specific needs of the buyer and seller. Forwards are not settled through a clearning house and because of this they expose the investor to counterparty risk. Futures Contract: A contractual agreement to buy or sell a particular commodity or financial instrument at a predetermined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. Futures are similar to forwards except they are standardized and traded on an exchange. Unlike forwards, future contracts are settled through a clearing house and marked-to-market daily to prevent a significant build in profits or losses on any side, thus reducing counterparty risk. Gamma: The rate of change of delta or hedge ratio with respect to the underlying asset's price. Gamma is a derivative of delta. Negative gamma indicates that the delta of the derivative will decrease toward -1 as the underlying rises. Hedge: A position established in one security to offset exposure to price risk in another. A position could be partially hedged or fully hedged. A partial hedge would only offset some of the losses whereas a full hedge would offset all of the losses. Hedge Ratio: See delta. Margin Call: A brokers demand that an investor using margin deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when an account value fells below a required threshold. Mark-to-Market: Recording the price or value of a security, portfolio, or account on a daily basis, to calculate profits and losses or to confirm that margin requirements are being met. Risk-free Rate: The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. Roll Yield: The return (positive or negative) realized by selling a shorter-term futures contract and replacing it with a longerterm contract that has a lower or higher price. If the price of the longer-term contract is lower than that of the shorter term contract, the futures curve is said to be in backwardation, and a positive roll yield, or profit, is generated. If the longer term contract costs more than the proceeds generated by selling the shorter term contract, the market is in contango, and negative roll yield is experienced. 6 Special Report

7 Reference Websites Website/Product Description Canadian listed leveraged and inverse leveraged ETFs U.S. listed leveraged and inverse leveraged ETFs U.S. listed leveraged and inverse leveraged ETFs The world s first triple-leveraged and triple inverse-leveraged ETFs U.S. and Canadian listed leveraged and inverse leveraged ETNs Index Providers Detailed information about the S&P/Barra family of indices Composition information, intra-day updates and historical data on the Dow Jones series of averages and indexes Morgan Stanley Capital International (MSCI) indices are international benchmarks widely used by global portfolio managers The Frank Russell family of broad-market and equity style indexes Information about Canadian debt market indices Standard & Poor's global indices coverage including methodology, news and index changes Dow Jones indices, also includes DJ-AIG indices Stock Exchanges This website provides info on the ETFs listed on the NYSE Arca exchange. Most of the U.S. listed ETFs have now moved to this division of the New York Stock Exchange. The American Stock Exchange's website provides information on all Amex-listed exchange traded funds, plus quotes and graphing tools AMEX TRADER contains specific end-of-day trading data for each ETF issue as well as historic data including distribution history Exchange Traded Funds section includes general, product and performance information on the universe of ETFs Toronto Stock Exchange website; currently home to all Canadian listed ETFs General Focused solely on the global ETF marketplace Daily pricing, fund searches, industry news and education on ETFs Includes and Exchange Traded Funds center with news, commentary and research The Advisor in Transition - The guide to building a fee based practice Source: Company websites 7 Special Report

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