Products like margin loans and contract for difference (CFDs) may have been the traditional face of leveraged and inverse investing, but the emergence of leveraged and inverse exchange traded products (ETPs) has changed the landscape.
We spoke to David Tuckwell, Editor for ETF Stream, Zac Zacharia, Founder and Managing Director for Centra Wealth Group and Adrian Rowley, Head of Equity Strategies for Watershed Funds Management about this growing space and how they are using these products.
Leveraged and inverse ETPs
While leveraged and inverse ETPs bear some similarity to exchange traded funds (ETFs) in that they are listed on a stock exchange and traded this way, they are managed and operate differently.
“A leveraged ETF is a bit like a magnifying glass. So it starts off with your regular old index, like the ASX 200 or the S&P 500, then it essentially magnifies the return on that index. If it's an Australian-style ETF, then it will magnify the exposure within a certain band. If it's an American-style one, it'll do it slightly differently and give you exposure, but a magnified exposure, but only for the day. Just to give a little bit of information on the inverse ones, the way they work is like a mirror when the market goes up, they go down and vice-versa,” says Mr Tuckwell.
Leveraged and inverse ETPs is a growing market in Australia – there are currently only 8 products listed on the ASX, compared to approximately 257 listed in the US (1). Australia may follow the path of the US to some extent, though Mr Tuckwell notes there are differences between the markets.
“Australia is not the United States. We're a very different country with different laws, with different regulations… In the United States, the way those leveraged inverse ETPs work is they give you the exposure just for one day… over the long-term, they go to zero, essentially, because of the way they compound. That's not allowed in Australia, those kinds of funds aren't allowed here… The way they work here is they're actively managed, they work like hedge funds and they try and give you a magnified or inverse exposure within a certain parameter. So, very different countries, very different laws, very different context,” he says.
Investors have shown increasing interest in and use of leveraged and inverse ETPs in recent months, with the most popular Australian listed inverse ETP tripling its assets since January. Market volatility related to the COVID-19 pandemic has been a key driver for this activity.
Mr Tuckwell says, “investors are looking for a way to either hedge against it or in some cases, trade into the volatility…They're trying to do it without necessarily resorting to short selling, or they're trying to do it without being able to access derivatives.”
Different ways of using leveraged and inverse ETPs
Mr Zacharia and Mr Rowley both use leveraged and inverse products for their clients, though in slightly different ways.
For Mr Rowley, it is about managing risk in the portfolio.
He says, “So, late last year and certainly early this year with the maturity of our market, with the valuation that was clearly stretched in some of those macro risk building, we built up a fairly substantial index short position within our Large Cap Aussie Equity SMA. So what that means is, we could keep a larger percentage of the portfolio intact. So reducing turnover, keeping more of the portfolio in top 100 stocks, getting that 4 or 5% dividend, but by buying a leveraged and increasing a position for exposure to a leveraged short ETF, we could really dial back the overall market exposure at a point where we thought that the market was clearly stretched. So for us, it's a way to manage risk, but we have actually bought geared ETFs as well.”
He views leveraged and inverse products as valuable tools in market volatility.
Mr Zacharia uses such products slightly differently and focuses more on using leveraged ETPs, rather than inverse.
“Where the client is moderate or high growth, that's where we bring in the geared Australian shares or international share ETPs as part of the core index exposure to those classes. Now, depending on the client, this can represent anything from 10 to 50% of the allocation. And where it works really well is if it's done in conjunction with a dividend reinvestment strategy. And that's where we really see the effects of compounding that works well in their portfolios,” says Mr Zacharia.
He uses inverse ETPs occasionally as a hedge against market volatility but feels the leveraging is not enough in these products and market timing also holds concern.
“You get the timing wrong and you really don't benefit as much as perhaps you should from those,” he says.
What to consider when using leveraged and inverse ETPs
Leveraged and inverse ETPs are sophisticated trading tools, and while listing on the stock exchange may make them accessible, this doesn’t mean they are suitable for all investors.
Mr Tuckwell says, “it's fair to characterise index funds and ETFs as more defensive kinds of products for the most part. These types of funds aren't necessarily like that. So I think the first and most critical thing for investors considering using these, is know the risks and know what you're buying.”
Similarly, Mr Zacharia says, “I think it's really understanding the risk versus reward story where it fits in the portfolio. Leverage is always going to be a double-edged sword and investors need to understand that you’ve got to take the good with the bad, I guess. Understanding the drawdown risk, if you are a passive investor in a traditional buy and hold sense. And remembering of course, that short ETFs are for the short term, dare I say it. Often people don't get the timing right, and they don't benefit from them.”
Mr Rowley shares this concern but also highlights the importance of their role within the broader portfolio.
“I think, for us, it's about really understanding how it fits within the client's broader portfolio. So, for us they're portfolio construction tools. So, it's about thinking how it fits within the broader portfolio and how that will change or alter the risk and return profile going forward,” he says.