The funds come courtesy of ETF Securities (ETFS), adding to their existing range of 51 ETCs. They will be priced off indices and sub-indices of the Dow Jones – AIG Commodities Index. The range comprises 19 individual commodities and 9 sub-indices in addition to four new commodities (Cocoa, Lead, Tin and Platinum). Of course, the burning question is do they have a place in your portfolio?
Leveraged ETFs or ETCs
Leveraged ETCs aim to magnify their exposure to a chosen market segment.
For example, ETFS Leveraged Gold looks to double the returns of the DJ-AIG Gold Sub-Index. Therefore if the DJ-AIG Gold Sub-Index gains 5%, the ETC should go up 10%. But keep in mind that the opposite is also true - if Gold drops 5%, this ETF would drop 10%.
ETF Securities use a combination of shorts, options, and futures in order to fulfil their product goals. This means that there are a lot of moving parts to these strategies, so there's no guarantee that they will achieve their objectives. As these investments are new to the UK market place it is difficult to see how they would perform in different market conditions, however across the water in the US leveraged funds do have a track record - and they are not without blemish. The key factor investors need to be aware of is that a fund such as ETFS Leverage Gold is looking to double the daily return of its index, whether its positive or negative. That's important, because any loss on a given day will be doubled, and the return needed to get back to even will be much greater than the offset provided by the fund's ability to double its next daily upside return.
Consider this scenario: You invest £10,000 in a fund that attempts to double the return of a daily index. The next day, the market crashes, and the index falls 40%. However, as the fund doubles your loss, your investment falls £8,000, leaving you with just £2,000 in the fund. An unleveraged offering tracking the same index would be worth £6,000, or three times as much. Now, assume there's hugely bullish news the next day and the index rises 60%. The unleveraged fund is now worth £9,600, almost back to break even. Your leveraged fund soars by double the index amount, a full 120%, but that leaves you with just £4,400.
A similar, though much less dramatic, scenario has played out Stateside with a leveraged offering called ProFunds UltraBull. The fund aims to produce twice the return of the S&P 500 on a daily basis. But rather than doubling its benchmark's performance over the last three years the fund has underperformed the S&P 500 index by some distance on an annualised basis (5.46% for the S&P 500 vrs just 2.92% for UltraBull, a huge margin on a annualised basis). Investors would have been much better off simply buying an index tracker. They would have received higher returns with substantially lower volatility.
Short ETFs or ETCs
Once again derivatives are used here, this time in an attempt to produce the opposite movements an index. So to take advantage of the previous example ETFS Short Gold aims to change each day by minus one times the daily percentage change in the DJ-AIG Gold Sub-Index. Therefore if the DJ-AIG Gold Sub-Index falls 5%, the ETC should go up 5%. But, again, keep in mind that the opposite is also true - if Gold rose 5%, this ETF would drop 5%. It is also important to remember that with both the short and leveraged products the returns we have used in our examples are before fees and adjustments – and with an annual management charge of 0.98% for ETFS Short Gold fees can really add up.
Do They Belong in Your Portfolio?
We think the answer for most investors is no. First, very few investors will be able to handle the kinds of volatility that these products bring with them. Recent research by Morningstar in the U.S. on Investor Returns (also known as asset-weighted returns) measured how the typical shareholder fared by incorporating cash flows in and out of funds. The study showed that investors often make their entry and exit into and out of funds at the worst possible times, typically buying as funds are peaking, and selling near troughs. Most important, the study showed that volatility exacerbates this behaviour--that is--investors do a much better job of using lower volatility funds well, but often cost themselves considerable sums when they try to use higher-volatility offerings. So when you take into account that the standard deviations of ETFS Nickel over the last year is 37.55, and imagine doubling it - it doesn’t look good for investors
Not only that, but the one of the main benefits of a product that allows you too short an index, or leverage up your exposure would be to try and time the market - and very few, if any investors, even the professionals, are much good at this.
Conclusion
The ETF marketplace within the UK has been expanding rapidly over the past year, and we expect even more providers to jump on the bandwagon over the coming 12 months. While it might be easy to get swept up in the hype surrounding the newest exotic offerings, we would advise you know exactly what you are getting into before taking the leap. If you really want to short gold, or leverage up your platinum exposure, make sure you do it with money you can afford to lose – especially if you want to sleep at night.
