Welcome to another edition of the ETF Insights newsletter. This month, we will be speaking on utilizing leverage inside ETFs and whether or not it could be a long-term benefit for passive investors.
Leverage inside ETFs has been a hotly debated topic. With many fund managers using leverage to amplify returns in this current bull market, I believe it’s worth discussing with members to help identify the pros and cons of the strategy.
At the end of the newsletter, I’ll drop some leveraged ETFs that I particularly like. If they fit your risk tolerance, you can certainly add them to your watchlist.
First, I want to announce a new feature we’ve added to the ETF Insights platform
I have decided to add Discord functionality to the ETF Insights platform. You can link your current ETF Insights account and access a private channel exclusive to ETF Insights members on our Discord server.
You can utilize the Discord to discuss popular ETF strategies, research, market commentary, and so much more with myself and other ETF Insights members.
Linking your account is easy. Simply log into your ETF Insights dashboard, select “Account,” and then click the button to link your account. Allow 5 minutes for the system to add the ETF Insights role to your account, and you should have access.
As always, Discord is a separate platform. Discord is free, must be downloaded individually, and an account has to be created.
See you inside the Discord!
The emergence of leveraged ETFs
Leveraged ETFs have exploded in popularity in a post-pandemic world. This makes sense, as outside of the bear market in 2022, we’ve been in a massive bull market. In a bull market, investors tend to get a bit greedy and seek out higher-than-normal returns.
For the most part, fund managers are going to look to extract the maximum possible amount of money from their unitholders (all while trying to achieve high returns), especially when it comes to niche ETFs like covered call, leverage, income, etc.
As a trend gets more popular, more ETFs emerge for this exact reason. Fund managers tend to put their efforts towards creating funds that are currently seeing large inflows.
For many, access to leverage is expensive. These major institutions get leverage at much cheaper rates than retail investors. As a result, the fund managers can offer more attractive situations for those who want to utilize leverage.
The dangers of leverage
Many investors get tunnel vision on returns during a bull market without acknowledging risks. This comes into play heavily when we look to leveraged ETFs.
When the S&P 500 is up 10%, it’s easy to look to an S&P 500 2x leveraged fund, see it up 20%, and want exposure to that higher return without acknowledging the risks. So, I’d like to go over a few of those risks.
Keep in mind that I’m not going to dig deeper into the more basic elements of leveraged ETF risk. I assume you know that larger gains come with the risk of larger losses in leveraged investment. Instead, I will go over some elements you may not know about that may surprise you.
What goes down has to come up… more
I feel that this is probably one of the biggest misunderstandings many people have about leveraged ETFs.
Yes, they are amplified in our favour when they’re going up. But when they’re going down, they present unique risks that result in us needing outsized gains to recover our capital.
Let’s break down a simple situation. You own $10,000 of a normal S&P 500 Index fund.
If that fund falls 10% in value, you will need approximately 11.1% returns to return to your initial $10,000. This is because your initial $1000 is lost, and you now need to earn on your $9000 remaining to get back to your initial value invested.
With leverage, it is even more amplified. Let’s say you own a 2X S&P 500 ETF (one that is exposed to 2X the movements of the S&P 500). In this situation, you would be down 20%, not 10%, and you’d need positive returns of 25% to get back to your initial investment.
Volatility decay
The types of movements I show above (needing an 11.1% return to recover a 10% loss, for example) are one of the main reasons volatility decay exists with leveraged ETFs.
I can’t tell you how many times I’ve had someone come to me with this situation after owning a leveraged ETF for a year: the underlying asset it tracks is slightly green or flat, and their leveraged ETF is in the red.
This is a result of volatility decay. Over time, leverage will erode results, and if we have a flat or even slightly green market, you can end up underperforming due to the resetting leverage and the returns not being symmetrical (11.1% gain for a 10% loss, as mentioned).
With daily resetting leverage, this can also happen in volatile markets to the upside, as the leverage resets daily.
To fully realize the advantages of leveraged funds, we need green markets. Even in the event of flat markets, we likely will not perform well. In down markets, it gets even worse.
For this reason, I’d avoid high (2x,3x) index and individual equity-based leveraged funds
Ultimately, this is up to you personally as an investor. If you’re experienced, understand the risks, and willing to take on the leverage of these funds, let’s say, for example, a 2X Nvidia ETF or a 2X S&P 500 ETF, go for it.
However, these investments are meant to be held over the short term. They are supposed to be utilized as trading vehicles, not investing vehicles. For this reason, I’d say they are not appropriate for the vast majority of investors.
If you own these funds long-term, volatility decay will erode your returns. Ultimately, the risks you’re taking to the downside will not be worth the less-than-optimal returns you’ll receive to the upside.
Another type of leveraged fund I’d avoid: covered call leveraged ETFs
Over the last few years, investors have caught on to the fact that covered call ETFs tend to underperform the underlying index they track, simply due to the covered call nature of those funds.
Many fund managers have started to counteract this by introducing leverage into these portfolios.
In general, covered calls cap your upside potential while providing little downside protection. When we add leverage to the mix, we increase our upside potential (and more holdings to write options on, increasing income), but not to the same degree that we increase our downside risk.
In 2024, fund managers are jockeying to produce the highest yield-jacked fund possible. I start to pump the brakes and analyze funds more closely to see what is truly being presented in situations like this.
A little bit of careful consideration can go a long way here.
Types of leverage I do like, and some ETFs that can give you exposure
I just want to reiterate that you must first decide whether leverage is within your risk tolerance before considering anything in this month’s newsletter.
None of the funds I will highlight are taking on extensive risks when it comes to leverage. At max, the funds I will highlight utilize around 25%. Anything more than that, and I believe an investor is asking for trouble.
However, 25% still adds volatility, and one must be comfortable with this before buying.
If you are comfortable with the added risk, some unique opportunities exist in leveraged funds.
I don’t mind leverage in lower volatility segments
Everyone has a pretty good idea of how they want to execute leverage. They want to buy a 2X leveraged S&P 500 ETF and laugh all the way to the bank.
However, as the old Mike Tyson saying goes:
“Everyone has a plan until they get punched in the mouth.”
Although I think most investors would be best suited to avoiding leverage altogether, if you can withstand the volatility, I don’t mind small amounts of leverage (say, 25%) in lower volatility sectors.
Hamilton is one fund manager doing this quite well with a couple of Canadian sectors.
I’ve often been critical of Hamilton’s covered call funds and “yield maximizer” funds. However, I give credit where credit is due. Hamilton has some pretty solid leveraged funds for those who are seeking exposure.
Let’s dig into two core ones, one of which is featured here as a shortlisted ETF and posted outstanding returns over the last year or so.
Hamilton Enhanced Canadian Bank ETF (HCAL.TO)
HCAL is a featured ETF here at ETF Insights, primarily because I still view Canadian banks as exceptional businesses.
If we look to the fund’s performance over the last year, it has outperformed an equal-weighted banking ETF by about 12%.
This fund holds an equal-weighted position in the Big 6 banks. Then, it utilizes 25% leverage to buy additional holdings of the banks. It does so through Hamilton’s equal-weighted banking ETF HEB.
You’ll see high fees for this type of fund. However, the fees are due to the leverage, and ultimately, it will be difficult for retail investors to get the same leverage rates as institutions. Sure, the fees are in excess of 1%. However, retail investors could pay rates like 7% or more to utilize leverage.
As always, leveraged funds are going to amplify returns but also amplify losses. However, with Canadian banks being low-volatility investments, I feel this situation is where I expect (but not guaranteed) leverage to work out over the long run. This is why this fund is featured here at ETF Insights.
The banks have experienced a slowing/stabilization of provisions for credit losses, and declining interest rates are resulting in a bit of relief for the Canadian consumer. As a result, earnings are normalizing, and share prices are appreciating.
Is the large runup in banks likely done? I would argue yes. The 45%+ annual returns from the institutions are a rarity that you won’t see too often. However, that doesn’t mean banks aren’t in a strong position to grow. If they can put up consistent earnings growth and share prices trend upwards, the leverage will only help fuel those returns.
I won’t speak much on HCAL in this newsletter as I want to move onto other funds. The best place to find more of our information on HCAL would be in our custom report, which I’ll link to here.
Hamilton Enhanced Utilities ETF (TSE:HUTS)
The success of HCAL was so strong that Hamilton decided to create another fund in a low-volatility Canadian sector: utilities. The fund has been around since 2022. Although it hasn’t done all that well, when we compare it to a benchmark like the BMO Equal Weight Utility ETF (TSE:ZUT), it has still outperformed (see the chart below).
If we continue to see utilities rise in price due to falling policy rates, there is a high likelihood that the Hamilton Enhanced Utilities ETF (TSE:HUTS) could outperform its benchmark while providing a rock-solid high distribution yield.
I’m fairly bullish on utilities in this environment in particular. I do feel that economic weakness here in Canada will result in amplified interest rate declines, ultimately helping utilities that tend to thrive in lower-rate environments.
This is exactly why we witnessed HUTS and ZUT perform so poorly during 2022 up until about midway through 2024. Rates started increasing and stayed elevated for quite some time, increasing the debt costs for utilities and making fixed-income investments a bit more attractive.
However, considering HUTS has leverage, what is astonishing to me is that there was only a brief period since its inception that it underperformed ZUT, which is not leveraged. You would think that with the leverage applied to HUTS, it would face larger drawdowns.
But, it just goes to show that leverage is not all that bad in industries that tend to offer lower volatility, and utilities is one of those industries.
How are the distributions so high on both of these funds?
One thing you’ll notice about these two funds is they don’t have any particular income-producing strategy attached to them, like covered calls, which helps increase the income a fund generates (to its detriment over the long-term, in my opinion).
However, what these funds will aim to do is collect dividends from the leveraged holdings along with capital gains (if realized) to amplify the distributions.
There is a possibility that during down years these funds will need to produce return-of-capital distributions to maintain yields. The leveraged component of the funds, plus the idea that banks and utilities had struggled in 2023, means there just wasn’t enough income and capital gains generated by the fund to pay out the full distribution. So in this situation, the fund would pay out return of capital to maintain the yield.
However, if banks and utilities stay in a bullish pattern moving forward, these funds won’t have any issues covering their large 7%+ distributions.
Overall, leveraged funds do provide larger upside potential, but they need to fit within your tolerance for risk
I am a fan of leverage under the right circumstances, and I do feel funds like HCAL and HUTS are using it responsibly. On the surface, they appear to be high-fee funds, but if an individual were to seek 25% leverage on a position, retail margin rates would be much higher than the institutional leverage rates these funds have access to, which can end up saving investors some money.
However, this entire newsletter boils down to you being able to figure out your individual tolerance for risk and whether or not you can handle the leveraged component of funds if they are something that has interested you.
I have spoken about 2 funds in this email. However, there are hundreds of leveraged funds out there, all with differing levels of leverage, types of leverage, and overall strategies.
This is where the Q&A for ETF Insights comes into play in a big way. If you have questions about a fund, head to the website and ask. I can help shed some light on some of your most burning questions in your journey of reaching conclusions for your portfolio.
