Day-to-day portfolio management is no longer a simple matter of growing capital or generating more income. It also includes limiting risk, dealing with unexpected shocks, and matching investment strategies with client expectations.
Along these lines, using long/short ETPs can help advisors to manage volatility, reduce risk, and even take advantage of strong directional movements in financial markets.
The long/short ETP universe offers outstanding asset coverage to stocks, bonds, commodities and currencies. Let’s see how these products operate.
Understanding the Goal
Long/short ETPs come in various flavors. Leveraged products are either 2x or 3x, meaning they aim for 200% or 300% daily leverage to their underlying index. On the other hand, –1x, –2x and –3x products have the goal of daily inverse returns that are 100%, 200% or 300% opposite their benchmark. Since today’s generation of long/short ETPs have daily goals, they are best used as short term trading instruments.
Another important aspect of long/short ETPs is their legal structure. Some products use an ETN wrapping, which exposes their owners to credit risk of the financial issuer. Products that use an ETF structure avoid this risk.
Regardless of their legal structure, all long/short ETPs that use derivatives are subject to counterparty risk. This can result in losses if the counterparty has difficulty meeting its contractual obligations in the securities transaction. While counterparty losses are generally rare, they are still possible.
Leverage Pros and Cons
Obtaining magnified exposure to a certain asset class without having to borrow money is one of the primary benefits of leveraged long/short ETPs. Unlike with traditional margin lending, the ETP investor pays no borrowing costs and cannot lose more than was invested.
Because of their daily goals, all long/short ETPs—even those without leverage—require careful monitoring. They are not buy-and-forget investments.
Let’s analyze three market scenarios and how leveraged ETFs would typically react:
Steadily rising markets. If the underlying index moves in a linear trend favorable to the leveraged ETF (up for a bull fund, down for a bear fund), the fund’s actual gain may be larger during a given period. Why does this occur? As the fund’s exposure rate increases, market gains are magnified based upon favorable index movements. Likewise, the fund’s assets will rise in response to sharp directional trends.
Steadily falling markets. What if the benchmark index moves sharply in an unfavorable direction (down for a bull fund, up for a bear fund) to the leveraged ETF? Interestingly, the losses for the fund in a given period might be less than expected. This happens because as unfavorable index moves take place, the fund’s assets decline along with its market exposure. As a result, this process mutes the adverse impact of subsequent index trends not favorable to the fund.