By LARRY SWEDROE
The use of exchange-traded funds (ETFs) has exploded, to the benefit of investors. They benefit from the structure of ETFs because they can operate more tax efficiently than mutual funds and generally have lower operating costs than mutual funds, resulting in lower expense ratios.Within the ETF world, leveraged and inverse ETFs have also exploded.
Leveraged funds, often called “ultra” funds, attempt to capture two or three times the daily return of an index. Inverse ETFs, also called “short” ETFs, attempt to capture -100 percent, -200 percent, -300 percent or even -400 percent of the daily return of an index. These products exist for various indexes, including broad market indexes (like the S&P 500), sector-specific indexes or even certain commodity indexes (like oil and gas).
My January 17, 2020, article for The Evidence Based Investor reviewed the performance of leveraged ETFs. The evidence of the extreme underperformance of these vehicles presented in the article clearly demonstrated the wisdom of the alert put out on August 1, 2009, by the Securities and Exchange Commission in conjunction with the Financial Industry Regulatory Authority (FINRA), warning investors that leveraged ETFs should not be held for periods longer than one day, as the performance of the instrument will diverge from its benchmark. The evidence showed that using leveraged or inverse funds as part of a broad portfolio strategy results in more volatility and may result in lower returns than even just using a simple unlevered index ETF strategy.
Given their poor performance, an interesting question is: Do institutional investors (considered to be more sophisticated than retail investors) use these products, and if they do, how does their use impact performance? Luke DeVault, H. J. Turtle, and Kainan Wang, authors of the study Blessing or Curse? Institutional Investment in Leveraged ETFs, published in the August 2021 issue of the Journal of Banking and Finance, utilised institutional 13F filings from September 2006 to December 2016 to find the answers. Following is a summary of their findings:
Institutional investment has expanded its footprint in leveraged ETFs.
More than 20 percent of quarterly institutional 13F filings report a leveraged ETF in their quarter-end portfolio. However, there is considerable variation in the types of institutions that invest in these assets.
University and foundation endowments and public pension funds do not appear to invest in leveraged ETFs. On the other hand, 35 percent of bank trusts do. Investment companies (26 percent), independent investment advisors (23 percent) and insurance companies (16 percent) are also prominent investors in leveraged ETFs.
The majority of leveraged ETFs held by 13F institutions (over 70 percent) track an equity index, followed by 10 percent that track a commodity index. Debt and other types (e.g., currency) account for the remaining leveraged ETF sample.
Institutions holding a leveraged ETF underperform relative to those that do not, and the best performing institutions make the least use of leveraged ETFs.
The underperformance of institutions holding a leveraged ETF over those without any leveraged ETF holdings for an equal-weighted portfolio of leveraged ETF institutions, after adjusting for commonly used market risk factors (beta, size, value and momentum), was an economically significant 0.5 percent per year.
The 95th percentile of institutions place 8 percent of their portfolios in leveraged ETFs, suggesting few institutions commit large portfolio weights to these investment instruments. That finding is not surprising given the short-term and high-risk nature of leveraged ETFs in most investment strategies.
There is a strong negative relationship between leveraged ETF holdings and future institutional performance. And the underperformance increases over longer horizons.
Leveraged ETF holdings are negatively related to past return performance — to lock in gains (possibly to preserve incentive fees), institutions eliminate holdings in leveraged ETFs following outperformance (which attracts assets).
The poor performance associated with leveraged ETF holdings appears most closely tied to poor market timing ability by leveraged ETF institutional investors. Timing sensitivity for institutions holding leveraged ETFs was significantly negative for institutions as well as for independent investment advisors—another example of the difficulty of market timing.
Their findings led DeVault, Turtle and Wang to conclude: “Institutions in aggregate do not benefit from exposure to leveraged ETFs. Rather, these instruments appear to be used by institutions prone to poor market timing.” Their findings beg the question: Why do these institutions continue to utilise leveraged ETFs?
Investor takeaway
The takeaway for long-term investors, and there should not be any other kind, is that leveraged ETFs should be consigned to the junk pile of products created by Wall Street that are meant to be sold, not bought.
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