The controversy over ETFs that offer 2 or 3 times the daily price movement of an index (up or down) is rooted in the wonky returns from an unprecedented period of volatility in capital markets in 2008 and early 2009.
The Foundation for Advancement of Investor Rights (FAIR) executive director Ermanno Pascutto has been clear in criticizing these products as misleading. His statement in the May 15, 2009 Jonathan Chevreau Financial Post article "Investor group blasts makers of leveraged ETFs" could be, with respect for the goals of the organization, better informed.
"There's a lot of detailed disclosure in the prospectus about risk but nowhere does it bluntly tell you you could be completely right in your selection of an ETF and find out that despite being right, you lose money". He goes on to say "In several cases, no matter which way you bet over the past year, you would have lost money."
One of the examples cited is the case of the Horizon BetaPro Global Gold + ETF. The underlying index, the S&P/TSX Gold Mining Index was up 0.9% for the year ending March 31, 2009 while the Bull + (2X) ETF was down 46.4% and the Bear + (-2X) was down 86.7%. At first glance this doesn't seem right. The fact is that each ETF delivered pretty much what they said they would, 2X the daily price movement of the index. The issue is the difference between arithmetic daily returns and geometric compounded returns.
It doesn't take much volatility to get these two different returns out of alignment. When volatility is as wild as it was for the 12 months ending March 31, 2009, the extreme results mentioned earlier are possible.
A way to estimate the impact of volatility on the returns of leveraged ETFs is as follows:
daily geometric return = daily arithmetic return - (0.50 X SD^2)
In the case of the S&P/TSX Gold Mining Index, the daily volatility was 5% and that of the HBP Bull and Bear + ETFs was 10%! Working through the above formula one derives an estimate of 0.50% per day. This translate into 72% per annum of volatility drag. In other words, assuming zero index movement for a year, an investor could expect a -72% return from volatility in this ETF. The investment strategy is very clear, if an investor expects a high level of volatility to persist; short the ETF.
If FAIR wanted to help the broadest base of individual investors, they would be doing better to demand that Canadian mutual fund prospectuses display costs on the front page in a type size that everyone can read so that Canadian investors would know that they are being charged the highest mutual fund fees in the world.