Can leveraged ETFs truly be a cornerstone of a long-term investment strategy? The premise of amplified returns is alluring, especially in Canada’s dynamic market. However, financial advisors urge caution, emphasizing the inherent risks associated with these instruments. While some see opportunity, others foresee potential pitfalls for the average investor.
A leveraged ETF uses financial derivatives and debt to amplify the returns of an underlying index, typically by a factor of two or three. For instance, a 2x leveraged ETF tracking the S&P/TSX 60 index aims to deliver twice the daily percentage change of that index. This can translate into significant gains when the market is rising. The appeal is obvious: accelerate your portfolio’s growth. But the downside is equally important: losses are also magnified, and the effects of compounding can erode value over time, particularly during periods of market volatility. This is where the complexity comes in.
Two Canadian leveraged ETFs frequently mentioned in investment discussions are the Horizons BetaPro S&P/TSX 60 2x Daily Bull ETF (HXU) and its inverse counterpart, the Horizons BetaPro S&P/TSX 60 2x Daily Bear ETF (HXD). HXU seeks to double the daily performance of the S&P/TSX 60, while HXD aims to double the inverse daily performance. These ETFs are not designed for buy-and-hold strategies. Instead, they are intended for sophisticated traders who understand the risks and actively manage their positions, often on a short-term basis.
The daily reset feature is a critical aspect to understand. Because these ETFs reset daily, their long-term performance can deviate significantly from the leveraged performance of the underlying index. This deviation is due to the effects of compounding, which can be detrimental in volatile markets. Dr. Elara Reynolds, a finance professor at the University of Toronto, explains: “The daily reset essentially locks in gains and losses each day. Over time, this can lead to a phenomenon known as ‘volatility drag,’ where the ETF’s performance lags significantly behind what you might expect based on the leverage factor and the underlying index’s overall return.”
“Leveraged ETFs are powerful tools, but they are not suitable for everyone,” says Mark Olsen, a certified financial planner based in Calgary. “It’s crucial to understand the risks and have a clear strategy before investing. Many retail investors simply don’t have the time or expertise to actively manage these positions.”
Consider a hypothetical scenario: an investor buys HXU expecting the S&P/TSX 60 to rise steadily. However, the market experiences a period of choppy trading, with daily gains and losses. The investor might be surprised to find that their HXU investment has underperformed, or even lost money, despite the S&P/TSX 60 ultimately ending higher. This is the consequence of volatility drag. “It wasn’t what anyone expected,” one investor from Montreal commented on a thread about leveraged ETFs on X.com. “I thought I understood the risks, but the reality was much harsher.”
So, what are the alternatives for investors seeking enhanced returns? Financial advisors often recommend a diversified portfolio that includes a mix of stocks, bonds, and real estate. For investors with a higher risk tolerance, options strategies or carefully selected growth stocks might be more suitable than leveraged ETFs. The key is to align investment choices with individual risk tolerance, financial goals, and time horizon. A financial advisor can help assess these factors and develop a personalized investment plan.
- Key Risks of Leveraged ETFs:
- Magnified losses
- Volatility drag due to daily reset
- Unsuitability for long-term holding
- Potential for significant deviation from the underlying index
The comments section on a recent Facebook post about leveraged ETFs reflected a spectrum of opinions. One user wrote, “I’ve made a killing with HXU!” while another cautioned, “These things are a gamble. Be careful!” The divergent views highlight the importance of doing thorough research and understanding the risks before investing.
Before jumping into leveraged ETFs, potential investors should rigorously analyze their financial literacy and risk appetite. Do you have the time and knowledge to actively monitor your investments and react quickly to market changes? Are you comfortable with the possibility of substantial losses? If the answer to either of these questions is no, leveraged ETFs are probably not the right choice. Consider low-fee index funds or exchange-traded funds (ETFs) instead. A simple online search for “best passive ETFs Canada” can provide useful starting points, but do your own due diligence. Don’t rush, do you know what to do before the markets turn sour?
Ultimately, the decision of whether to invest in leveraged ETFs is a personal one. While the potential for amplified returns is tempting, the inherent risks cannot be ignored. For the vast majority of investors, a more conservative approach, focused on diversification and long-term growth, is likely to be a more prudent strategy. Ignoring the warning signs could be a costly mistake.