If you’re bullish on energy, gold, or a number of other sectors, there are various ways to invest in the thesis. You can choose any number of companies in the sector. You can choose a sector ETF. Or you can invest in a leveraged ETF.
On the surface, leveraged ETFs look like simple products. Say you’re bullish on oil. By investing in the Horizons BetaPro NYMEX Crude Oil Bull Plus ETF (TSX:HOU), investors get exposure to 200% of the daily performance of the price of crude oil. This seems like a good deal to someone bullish on the commodity.
But it’s not quite that simple due to a couple of things, namely tracking error and volatility drag.
Tracking error is a relatively simple concept. Since an ETF is only a close approximation of an index, over time it will only get pretty close to matching the performance of that index. Things like management fees paid by investors mean the performance will never match. These tracking errors get bigger in leveraged ETFs.
The bigger issue is volatility drag. Say crude oil shoots up 5% one day, down 2% the next day, and down 3% the day after that. Because the ETF uses daily options to magnify price moves, it’ll end up down approximately 1% while a non-leveraged ETF ends up pretty much flat.
Volatile markets are especially dangerous for leveraged ETF investors as they increase the volatility drag over time.
So the next time you’re bullish on gold, instead of buying the Horizons BetaPro Global Mining Bull Plus ETF (TSX:HMU), consider a straight gold ETF or a favourite gold company. That way you’ll avoid tracking error and volatility drag.
