“Having leverage is a double-edged sword,” says Mike Khouw on options-based strategy funds

Key Concepts

• Options Market Growth: The options market has experienced substantial compound annual growth rate (CAGR) exceeding equity volume growth.
• ETF Evolution: Exchange-Traded Funds (ETFs) have evolved to incorporate derivatives and options-based strategies more extensively.
• Retail Investor Behavior: A shift in retail investor mindset, particularly among younger investors, seeking higher potential returns beyond traditional market averages.
• ETF Issuer Competition: An "arms race" among ETF issuers to offer products with high leverage or distribution rates to attract investors.
• Leveraged and Inverse ETFs: ETFs designed to amplify returns (leveraged) or profit from market declines (inverse), often with daily resets.
• Total Return Swaps: A financial derivative used by some leveraged ETFs to achieve their stated objectives.
• Tracking Error: Discrepancies between an ETF's performance and its underlying benchmark, often exacerbated by choppy markets and frequent adjustments in leveraged products.
• Defined Outcome ETFs: ETFs that offer pre-defined return or income levels, with capped upside and buffered downside.
• Democratization of Products: The ETF wrapper's ability to make complex strategies, like options-based ones, more accessible to a wider range of investors.
• Investor Education: The critical need for investors to understand the underlying mechanics and risks of complex financial products.

ETF Market Growth and Derivatives Integration

The ETF market has witnessed significant expansion, with over a thousand new ETFs launched this year alone, a record number. A notable trend is the increasing integration of derivatives and options-based strategies within these ETFs. Approximately one-third of the new ETFs launched this year utilize some form of leverage. This growth is driven by both increased supply from ETF issuers and a perceived demand from investors, particularly retail investors, seeking higher potential returns.

The Role of Options and Derivatives in ETFs

The options market's compound annual growth rate has significantly outpaced equity volume growth. This expansion is partly attributed to the proliferation of shorter-dated options, including weekly and even daily options. While this offers opportunities, it presents logistical challenges for individual retail investors who may not have the time or expertise to manage them. ETFs that employ options-based strategies can "democratize" these complex products by offering a managed solution.

Leveraged and Inverse ETFs: Mechanisms and Risks

Many leveraged and inverse ETFs track daily performance of underlying assets. These products often employ strategies such as total return swaps for lightly leveraged ETFs. For others, achieving advertised leverage involves regular adjustments to the underlying portfolio.

Key Risks Associated with Leveraged and Inverse ETFs:

• Tracking Error: In volatile or choppy markets, frequent portfolio adjustments by fund managers can lead to tracking errors, causing the ETF to deviate from its intended benchmark.
• Leverage as a Double-Edged Sword: While appealing in rising markets, leverage amplifies losses in declining markets. Leveraged products can significantly underperform their underlying assets during downturns.
• Daily Reset Mechanism: The daily reset of leveraged and inverse ETFs means that performance is calculated on a day-to-day basis. This can lead to compounding effects that deviate from the expected long-term performance of the underlying asset, especially in volatile environments. Investors may not fully grasp these risks.

Investor Mindset and ETF Issuer Strategies

A significant shift has occurred in the mindset of retail investors, particularly younger ones. The historical average stock market return of 8-9% is perceived as insufficient, leading them to seek riskier products with the potential for "astronomical returns."

This demand has fueled an "arms race" among ETF issuers to offer products with higher leverage or attractive distribution rates. For issuers, a successful leveraged or inverse ETF can be a substantial revenue generator, given the typically higher fees associated with these products. These issuers often do not compete directly with the largest, established firms like Vanguard, iShares, and State Street, which generally do not launch these types of products.

Adoption by Wealth Managers and Financial Advisors

The use of leveraged and inverse ETFs by registered investment advisors (RIAs) and wealth managers varies.

• Tactical Trading Strategies: Advisors employing more tactical trading strategies may find leverage or inverse products useful tools.
• Long-Term Allocators: The majority of financial advisors, who focus on long-term asset allocation, tend to avoid these products, often described as not touching them "with a 10-ft pole."

Fee Structures and DIY vs. Managed Strategies

ETFs employing options-based strategies often have higher fees compared to traditional index-tracking ETFs. For instance, options-based ETFs might charge around 99 basis points (1%), while an S&P 500 ETF could have fees as low as 15 basis points or less.

Considerations for Investors:

• Understanding Underlying Securities: Investors should educate themselves about the underlying securities and futures that ETFs trade. This knowledge empowers them to understand what they are buying and make informed decisions.
• DIY vs. Professional Management: For investors who understand futures and options, implementing strategies themselves could be more cost-effective. However, for those who lack the time or expertise, paying the higher fees for a professional to manage these complex strategies via an ETF might be a reasonable trade-off.
• Distinguishing ETF Strategies: It is crucial for investors to understand the difference between various ETF strategies. For example, an ETF trading leveraged total return swaps or one aiming for convexity through constant position adjustments differs significantly from an ETF selling covered calls, which is an almost opposite strategy. Understanding these differences becomes critical, especially when volatility increases, to comprehend the ETF's behavior.

Leveraged/Inverse ETFs vs. Defined Outcome ETFs

There's an interesting juxtaposition between leveraged/inverse ETFs and defined outcome ETFs.

• Defined Outcome ETFs: These ETFs offer more clarity to investors and advisors due to their pre-defined outcomes. Investors know the upside cap and downside buffer. This clarity has led to significant adoption by financial advisors.
• Leveraged/Inverse ETFs: These products carry the potential for significant losses, and their exact outcomes are less predictable. This inherent uncertainty is why traditional financial advisors are hesitant to incorporate them.

Conclusion and Future Outlook

The ETF wrapper has democratized access to complex financial products, including leveraged and inverse strategies, making them more cost-effective. However, a significant concern remains that many retail investors do not fully understand how these products work. This lack of understanding is likely to lead to investors getting "burned" at some point, which appears to be an inevitable outcome for a segment of the retail market. While these products can solve market problems, investor education and a thorough understanding of the underlying risks are paramount.