Financial Jungle

Know The Risk: BetaPro TSX 60 Bull Plus ETF

Posted by Financial Jungle Guy
July 6, 2007

I was quite skeptical when Horizon BetaPro released this leveraged ETF at the beginning of this year. It promises to double the TSX 60’s daily volatility before various fees. For instance, if the index is up 1%, the ETF rises 2%. Conversely, if the index is down 1%, the ETF dips 2% as well.

Despite Horizon’s emphasis on daily performance, I believe the ETF should emulate two-times the index’s long performance provided that (a) the short-term amplifications remain consistent, and (b) the volatility is tame.

On the surface, this strategy is more electrifying compared to the alternative of direct leveraging. Let’s assume you like to double your TSX 60 holding with borrowed money at 6% prime. If the index is up 10% over the next 12 months, then your return on investment is 14% (10% plus the 4% on the borrowed money after paying for interests). With BetaPro, your ROI is 20%. Sweet! Secondly, with borrowed money, you can lose more than your ante, if the index tanks by more than 50%. With BetaPro, you only lose what you invested.

However, here’s the problem: the arithmetic breaks apart in a volatile market. For instance, if your $100 index fund declines 20%, and recovers 30% the next day, the resulting balance is $104 ($100 x 80% x 130% = $104). Effectively, you’re up 4%. On the other hand, when your $100 in BetaPro declines 40% and recovers 60%, the resulting balance is $96 ($100 x 60% x 160%). You’re down 4%, not doubling the index’s return. There’s no free lunch!

Arguably, this could be the most vulnerable time to double your exposure to this index after nearly five-years of uninterrupted prosperity. Investors should thread carefully.

This ETF is only six-months old, but the short history looks promising so far. The MER is 1.15% on your invested capital, or 0.575% when you spread it across the exposure. Since I’m more of a buy-and-hold investor, I may consider this ETF as long as it has the potential to reach my investment goal in half the time. Having said that, I’ll patiently observe how the ETF behaves over a complete market cycle prior to jumping in with both feet.

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Categories: Investing; ETFs

Reader Comments

Comment Number:: 1
Written by:: nobleea
Posted on:: July 6, 2007 at 10:05 pm

I don’t know how Betapro are able to have twice the daily volatility. What kind of instruments do they use? I have bought Betapro TSX 60 Bear fund (HXD-T) and have successfully traded it. Its good when you think the market is getting close to a top and want to profit from downside. Another way to look at it is insurance on your long positions.

Comment Number:: 2
Written by:: S. B.
Posted on:: July 7, 2007 at 4:02 am

Some quotes directly from the prospectus (my capitalization emphasis added for some items):

“The HBP 60 Bull+ ETF seeks daily investment results, BEFORE fees, expenses, distributions, brokerage commissions and other transaction costs, that endeavour to correspond to two times (200%) the daily performance of the S&P/TSX 60 Index®.”

“With respect to the HBP Bull+ ETF, under the Initial Forward Documents, the value of the purchase price payable thereunder will be reduced by an amount equal to 0.20% per annum of the notional amount of the forward price, calculated and applied daily in arrears. This amount effectively equates to a nominal annual fee of 0.20% with respect to the HBP Bull+ ETF.”

“The Portfolio Manager may invest in securities or financial instruments that are not included in the S&P/TSX 60 Index® or may weight certain stocks or industries differently than the S&P/TSX 60 Index® if the Portfolio Manager believes it is appropriate in view of the ETF’s investment objective, including money market instruments and other income producing instruments.”

“The Portfolio Manager may choose to avoid investment exposure to all of the equity securities or components comprising the S&P/TSX 60 Index®, or the ETF’s weighting of investment in such securities or industries may be
different from that of the S&P/TSX 60 Index®.”

“Each ETF will GENERALLY not use leverage in excess of 2.0 times its net asset value. If an ETF uses leverage in excess of 2.0 times its net asset value, it shall GENERALLY reduce its leverage to 2.0 times its net asset value within 10 business days.”

“Each ETF will pay the Manager an annual Management Fee equal to 1.15% of the net asset value of the Units of that ETF.”

“Leverage may involve the creation of a liability that does not entail any interest costs OR the creation of a liability that requires an ETF to pay interest, which will decrease the ETF’s total return to its Unitholders.”

“So while in this example the ETF has succeeded in meeting its 200% daily investment objective, it DOES NOT and SHOULD NOT BE EXPECTED to return 200% of the index over ANY PERIOD OF TIME OTHER THAN DAILY.”

Uh…I’ll pass on this one. I’d use a lot of caution here (as you mentioned). The potential savings of the 6% borrowing cost for a similar strategy does not come free, as you have very high fees, possible loss of dividend income, possible pass-through of interest costs, way too much latitude given (in my opinion) to pursue strategies outside the main objectives, and a general lack of transparency about how they intend to structure the derivatives. Not to mention the introduction of a lot of additional miscellaneous risks that each have low probability, but are nonetheless embedded costs…

Comment Number:: 3
Written by:: Financial Jungle Guy
Posted on:: July 7, 2007 at 4:14 am

I find it hard to wrap my head around the concept of hedging an index. If one security is going up, another is going down, and you paying fees between the two, wouldn’t the net result be negative?

BetaPro ETFs are great tools for traders, but the math in my post proves that they don’t necessary hedge the market.

Here’s another example for BetaPro Bear: $100 in index surges 20% in one day, and plunges 20% the next. The new balance is $96 ($100 x 120% x 80%). One would think that BetaPro Bear should be up 8%, since this ETF amplifies the inverse direction twofold. Let’s find out. The ETF would go DOWN 40% in day one and UP 40% in day 2. The new balance is $84 ($100 x 60% x 140%). BetaPro Bear amplifies the pain fourfold.

According to Bhavna Hinduja, fund analyst with Morningstar Canada:

Note that the objective of these funds is to produce returns corresponding to the daily and not the monthly or annual performance of the underlying index. As a result, their month-end or annual returns will not necessarily be the multiplier times index returns.

Comment Number:: 4
Written by:: nobleea
Posted on:: July 9, 2007 at 3:40 pm

No, I was suggesting keeping them for a week or two if you think you’re getting close to a top. Say you have a portfolio of blue chip-type stocks. You buy some HXD as insurance. Insurance is just piece of mind and safety net, most times we don’t use it and consider the premiums sunk money. If the index did have a big down day (say 10%), your HXD would be up 20%. Since your other stocks would be down about 10%, you could sell the HXD and buy more of your stock portfolio at a good discount (the 10% that they’re down, plus the 20% extra that your HXD is up). This is an easier way than buying put options on your stocks (which would be a better way to hedge/insure your portfolio).

Know The Risk: BetaPro TSX 60 Bull Plus ETF