As the recent market volatility made clear, there’s a big difference between plain vanilla ETFs and leveraged products making big bets with big risks.
I love movies that pivot on mistaken identity. From Desperately Seeking Susan(Madonna) to The Big Lebowski (Jeff Bridges), I get hooked when one character is falsely assumed to be another. But, mistaken identities should be reserved for the movies, not the exchange-traded products (ETP) market.
Over 97% of the $5 trillion global ETP market consists of exchange traded funds (ETFs): the plain vanilla, traditional, open-end index funds that can be bought and sold like a stock. (Source: BlackRock Global Business Intelligence.) Most ETFs are designed to do what they say on the tin: help investors target returns of stocks and bonds. Indeed, the lion’s share of ETF assets are in major, broad-based market indexes that are the building blocks of global asset allocation. ETFs are intuitive and well understood.
There is also a small subset of ETPs that use financial engineering in an effort to magnify returns on different markets. These niche products are worth roughly $80 billion in assets, or a paltry 1.5% of the overall ETP market, according to BlackRock GBI.
Unfortunately, these products are often mistaken for plain vanilla ETFs. Here’s why it’s a problem. The financial engineering employed in these products includes the use of borrowed money (leverage) to magnify returns, as well as derivatives like options that stand to gain or lose money based on fluctuations in market prices.
For example, inverse ETPs seek to deliver the opposite performance of the indexes they track. And leveraged inverse ETPs seek to deliver a multiple, say two or three times, of that opposite. Many of these products have complicated provisions that trigger early liquidations when there are large price declines and periodic resets of leverage factors, which means the performance of “geared” ETPs can be very different than that of traditional ETFs.
Our experience is that these complex provisions are not intuitive or well-understood by many users of the products. Indeed, prospectus disclosures for geared ETPs generally state that they may not be suitable if you seek an investment with a longer duration than a daily basis.