Leveraged exchanged-traded oil products are surging on rising oil prices. Such funds have risen nearly 90% since the start of the year, making them some of the top exchange-traded funds (ETF) of 2019 as U.S. oil price futures have risen more than 28%. But even as oil prices are expected to climb higher on fears of a global supply glut, investors are pulling out hundreds of millions of dollars from these leveraged funds, according to the Wall Street Journal.
3 Risky ETFs
Source: Wall Street Journal; YTD performance as of March 13, 2019.
What It Means for Investors
Leveraged investing can amplify returns, and in the case of the VelocityShares 3X and United States 3X funds, by as much as three times. The ProShares Ultra fund aims for double the daily performance. But leverage implies that losses are also amplified and if investors don’t understand the complexities of these investment vehicles, they can easily get burned.
Leveraged ETFs are generally reset on a daily basis. Whatever gains are made throughout the course of the day, the fund will need to rebalance in order to maintain a constant leverage ratio, whether it be 2X or 3X the amount invested. A $100 investment in a leveraged ETF with 2X leverage will have a $200 exposure to the underlying index. If the index rises 5%, the $100 investment will earn $10. But now the investment is worth $110 with an exposure to the index of $220. If the next day the index declines by 5%, then the loss on that day will be $11, resulting in an overall loss of $1 or 1% on the original investment.
Being unaware of how rebalancing works can evidently lead to big surprises for investors who want to use leveraged funds as part of a buy-and-hold strategy. While leveraged ETFs tend to do well in steadily rising environments with minimal volatility, large day-to-day swings can have significant adverse effects. Rebalancing in an uptrend with large daily swings essentially amounts to buying the highs and selling the lows. That’s usually never a good strategy, which is why leveraged ETFs tend to be marketed as daily trading tools, not long-term investment vehicles.
“If you get a whipsaw pattern, even if it’s moving overall in the direction that you pick, you could find yourself unpleasantly surprised because of all the buying high and selling low you did along the way,” Elisabeth Kashner, head of ETF research and analytics at FactSet, told the Journal. Over the past year, while oil prices are down only 7%, triple-leveraged products have lost nearly 40%, according to FactSet.
Currently, the price of oil is facing upward pressures from sanctions on OPEC members Iran and Venezuela as well as protests in Algeria. But considering the Trump administration has deemed lower oil prices as a central aspect of its economic policy, there remains uncertainty as to how high prices will go. Aside from the day-to-day volatility risks inherent to leveraged ETFs, oil traders will need to gauge the risks of a sudden shift in the current upward trend in oil prices.