2023 was a volatile year for investors, even if it seems to be heading into a happier ending than the last one. For investors who prefer passive products, Canadian exchange traded funds (ETFs) are a good bet, because of their transparency, and low fees. This year, some of the top performing ETFs have over 100% returns for the year.
Much like with the top performing mutual funds of 2023, the top ETFs also are dominated by cryptocurrencies, because of the run up in the underlying assets. Bitcoin has risen to over US$ 41,000 (As of Dec 11) from US$16,613 at the start of the year. Ethereum also had a volatile year, up to US$ 2185 from US$ 1200 at the start of the year.
But only one of the top 10 ETFs in Canada is not a cryptocurrency ETF, and this is the BetraPro Natural Gas Inverse Leveraged Bear ETF (HND). More on that later, but first, here’s the list:
“Bitcoin and cryptocurrency are even more strongly represented on the ETF list that they are in the mutual funds list,” said Morningstar director of manager research Danielle LeClair, “There remains only a handful of asset managers that offer these funds. Fidelity, CI, 3iQ Corp and Purpose each offer funds in both mutual fund and ETF vehicles, but the participation of Horizons and Evolve (two dedicated ETF shops) widen the universe for investors to choose from,” she added.
As Morningstar Director of investment research Ian Tam warns, though, cryptocurrencies as an asset class are fraught. "The eye-dazzling returns of crypto assets over 2023 should not be considered without broader context. Recall that an investor who took a position in Bitcoin at the peak of the market (unfortunately, many did) ramping up to the tail end of 2021 is still sitting on a significant loss despite this year's crypto rally,” he said.
While we have discussed cryptocurrencies in detail, we have spoken less about leveraged ETFs. Investors should be wary when considering these products for the long term.
Are Leveraged ETFs for Me?
Investors would be forgiven for wanting to explore leveraged ETFs, especially when they see a 200+% return over one year. However, you should keep a few things in mind. Leveraged/Inverse Leveraged ETFs use leverage to magnify investor returns. These funds typically hold derivatives to get a leverage ratio of two to three times the daily performance of a specific commodity, or index, or benchmark. Sometimes, though, irrespective of the performance of the underlying security, over the long term, you could see lower returns on your leveraged ETF. This is because of something known as “volatility decay.”
“While losses compound over time, leverage can lead to huge returns over shorter periods when there’s a consistent trend. For example, HND’s performance exploded during a persistent downward trend in the price of natural gas in 2023—one that resulted in a 60% loss by the S&P GSCI Natural Gas TR index for the year through November,” said Bryan Armour, Morningstar’s Director of passive strategies research.
Let’s explain that some more. Leveraged ETFs typically reset the leverage regularly, daily even. This means that when prices go up, they need to buy more of the underlying security, and when prices fall, they need to sell more. Essentially, they “Buy high and sell low.” While this might work out well for investors who trade these ETFs on a daily basis, over the long term, these losses compound. So even if the underlying security has gained, you might end up losing money.
“Leverage has its own compounding effect when things move in the right direction. But choppy markets or a move in the wrong direction are detrimental to performance. Traders can use these as daily tools to express a very short-term opinion or to hedge a position. I wouldn’t recommend that investors hold these products,” Armour says.
Simply put, these products are not designed for long term investors, and should probably not be held for more than a few days. This author leant from experience, when she bought a leveraged cannabis ETF, held it for a week, and ended up losing in the double digits. I only stick to diversified balanced ETFs now!
Armour notes that my experience was not unique. “High returns are the siren song that lures investors to shipwreck. There will always be periods of top performance for leveraged funds, but it’s almost impossible to consistently predict when those returns are coming. Off-years can be punishing. Remember, it takes a 100% return to get back to even after a 50% drawdown. And poor performance tends to snowball as investors try to recoup losses. Slow and steady wins the race!”
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