Leveraged exchange-traded funds (ETFs) seek to magnify the daily performance of the underlying indices, sectors or commodities they track. But be warned: They’re specifically aimed at knowledgeable clients, who understand how they work and the risks involved, as either a speculative or a risk-mitigation tool.

“They’re somewhat complex and complicated for the average investor. And they’re difficult to play with,” cautions Kevin Sullivan, vice president, portfolio manager and advisor in Toronto with MacDougall MacDougall & MacTier Inc.

Similarly, Kevin Gopaul, senior vice president and chief investment officer with BMO Global Asset Management Inc. in Toronto, contends that leveraged ETFs are “good trading tools that are driven by volatility and high-frequency volumes but are short-term in nature and best suited for sophisticated investors.”

However, Jaime Purvis, executive vice president, national accounts, with Toronto-based Horizons Horizon ETFs Management (Canada) Inc., argues that they’re not necessarily useful only in the short term: “Leveraged ETFs are simply outstanding tools in the right market conditions for clients.”

And the vast majority of the investors who use leveraged ETFs in Canada are direct investors, he says: “We have a very devoted and loyal following among the direct investor community who use these ETFs. Generally, they’re committed and have a high degree of market knowledge and the time to monitor their investments in order to maximize return and reduce risk.”

In Canada, leveraged ETFs seek to provide two times the daily performance of the indices, sectors, or commodities they track while inverse leveraged ETFs seek to deliver the opposite of the performance of the underlying indices, sectors or commodities. In the U.S., investors can gain access to up to three times leverage or inverse leverage — and Gopaul believes “it’s not far away before we see ETFs with three times leverage [in Canada].”

“They tend to have a much higher risk/return profile than non-leveraged ETFs. But typically over any given period, leveraged ETFs will dominate the list of both the top-performing ETFs and the worst-performing ETFs,” Purvis says. And when included as part of a portfolio, “leveraged ETFs can be used to enhance returns or as a hedge,” he adds.

It all depends on how they’re used. For example, if an inverse leveraged ETF is used as a hedge — allowing an investor to protect a $2 position with a $1 investment — then it’s actually a risk-mitigation tool, says Purvis. In such cases, the client might be bullish on Canadian equities, overall, but bearish on bank stocks and could hold an inverse financial stock ETF to hedge that risk in his or her portfolio.

On the other hand, leveraged ETFS can be used as a speculative investment. In this case, the investor will get two times the daily returns of the underlying index if it goes up and two times the losses if it goes down, which means that gains as well as losses can be multiplied.

In theory, investors must have a “high degree of conviction” to bet on the underlying index going up or down to be successful — and very few are right,” cautions Michael Cooke, head of distribution with PowerShares Canada, a unit of Invesco Canada Ltd., in Toronto. “The rule of thumb when investing in leveraged ETFs is that the duration of the holding should match the frequency of rebalancing.”

A common area of misunderstanding with these ETFs is around how the daily resets work on investor exposure, Purvis suggests.

In order to limit the risk of the investment and ensure that investors don’t lose more than their principal investment, “the ETF’s exposure has to be reset on a daily basis back to two times,” he says. Otherwise, they can end up losing money in volatile markets in the short term even if the longer-term value of the underlying index does not change.

For example, assume an investor buys a leveraged ETF on Day 1 for $100 a share when the index is at 10,000. The following day the index goes up by 10% to 11,000. As the investor has two times leverage, the value of the ETF goes up by 20% to $120.

Let’s then assume the investor does not rebalance his or her exposure and holds on to the ETF. The next day, the index loses 9.1%, falling from 11,000 to its Day 1 level of 10,000. This means that the value of the ETF would fall by 18.18% (two times the index), or by $21.82. The investor’s ETF is now worth $98.18 (or $120 – $21.82) while the index is still at the 10,000 level, resulting in a loss of $1.82.

Furthermore, this loss doesn’t include any commissions or fees, which the investor would have paid. Over time, these losses can be compounded, although compounding can work both ways, augmenting gains as well.

However, there are cases in which investors can make money by not rebalancing their ETFs daily. Purvis argues that “generally speaking, leveraged ETFs work on trends. So, if the market value of an underlying index moves in one direction with relatively low volatility, your exposure should be close to two times beyond one day.” And if you can ride the upward trend, “you can make money using leveraged ETFs.”

For example, he says that “Horizons BetaPro S&P 500 Bull Plus ETF, which delivers two times the daily return of the S&P 500 [composite index] made a 52% return on a one-year basis, ended Feb. 28, vs the S&P 500 itself, which was up roughly 25% over the same period.” In this case, investors could have held the ETF for a year without rebalancing and have obtained two times the underlying index’s return — indicating that leveraged ETFs can work successfully for more than one day.

In spite of the pros and cons of using leveraged ETFs, they have been the subject of criticisms and warnings from regulatory bodies, largely because of compounded losses that some investors have suffered resulting from a lack of understanding of how they work and how to use them.

Leveraged ETFs must be marketed with caution, suggests Gopaul, who recognizes that they can be “mis-sold.” Purvis contends that “each dealer tends to deal with leveraged ETFs differently; [and] some don’t allow their advisors to use them.” He adds that “most advisors require additional compliance requirements, such as an options licence or an internal proficiency requirement, in order to buy or sell leveraged ETFs on behalf of a client.”

In terms of costs, the standard management fee for leveraged ETFs in Canada is 1.15%, which is higher than traditional ETFs because the leveraged ETF borrows money to invest. But, on average, this remains lower than the fees for mutual funds.

At the end of the day, although risky, “if used appropriately, leveraged ETFs can be efficient,” Cooke suggests.

This is part three of a three-part web-exclusive special feature accompanying Investment Executive’s ETF Guide for Financial Advisors.