Leveraged ETFs have become popular with Canadian investors, as more and more of us realize a simple truth. If we’re bullish on a commodity, sector, or even the market in general, then using a leveraged ETF to get 200% exposure can lead to even bigger gains.
Inversely, bearish investors can double their short exposure by loading up on the various ETFs with 200% exposure to the downside.
But it isn’t quite that simple. Leveraged ETFs suffer from something called tracking error.
A regular ETF simply buys and holds the stocks in the underlying index. It takes long-term positions, only making a change when necessary. This is a good thing; it helps keep costs down.
Leveraged ETFs don’t. They use things like futures contracts and derivatives to rebalance much more often, usually daily. This leads to tracking errors over time.
As an example, let’s compare Canada’s largest ETF, the iShares S&P/TSX 60 Index Fund (TSX:XIU) and the Horizons Betapro S&P/TSX 60 Bull ETF (TSX:HXU). Over the last year, XIU is up 7.33%, while the Horizons leveraged ETF tracking the same index is up 16.4%.
In this case, the tracking error actually worked out in the investor’s favor. But it doesn’t always work like that.
Over the five years, investors betting against the TSX 60 using Horizons Betapro S&P TSX 60 Bear ETF (TSX:HXD) are down 18.6% annually, versus an increase of 8.4% annual for the index. You’d expect that loss to be closer to 17% based on the math.
