Lightly leveraged ETFs – a good fit for return-seeking investors?

While backtest data confirms return-enhancing potential, portfolio manager says there's more to consider

Lightly leveraged ETFs – a good fit for return-seeking investors?

As affordability challenges and economic uncertainty continue to run rampant, the pressure for Canadian investors to earn more from their portfolios has only grown. Against that background, there’s been an increase in ETFs offering lightly leveraged exposure to certain sectors of the stock market – but are they a fit for everyone?

Chris Kerlow, senior portfolio manager at Team LWC with CG Wealth Management, says lightly leveraged ETFs are a tool in their practice’s portfolio management toolkit, but not a significant part. As higher interest rates raise the costs associated with leverage, he argues they should be used only for high-conviction ideas where a better risk-return profile is sought over a longer period.

“We use lightly leveraged ETFs when we think that valuation discounts have widened substantially and over the longer term, there's a good opportunity for outsized returns,” Kerlow (pictured above, left) says. “When we're slightly less certain of the outcome, we tend to use more covered-call strategies, so that we're earning income and decreasing risk.”

Recently, Horizons ETFs launched a new suite of enhanced ETFs, including the Horizons Enhanced Equal Weight Banks Index ETF and the Horizons Enhanced S&P/TSX 60 Index ETF. They offer lightly leveraged index exposure to Canadian banks and the S&P/TSX 60, respectively.

“More and more, Canadians are seeking ways to enhance their investment return and income potential. Light leverage can offer that opportunity,” says Rohit Mehta, the firm’s president and CEO (above, right). “Historically, large-cap Canadian and U.S. equities, as well as Canada’s Big Six banks, have provided steady returns and dividends, with a level of stability that is typically expected from blue-chip companies.”

‘A little leverage can go a long way’

Backtest data provided by the firm show that over the 10-year period ending on May 31, 2023, an initial investment of $10,000 in the Solactive Equal Weight Canada Banks Index would have grown to roughly $27,000. With light 1.25x leverage, that investment would increase to just over $33,000.

Another backtest revealed that a $10,000 initial investment in the S&P/TSX 60 index would have grown to just over $22,000 by the end of that decade period, compared to roughly $26,000 with the use of light leverage.

“A little leverage can go a long way – based on back-tested data, an ‘enhanced’ approach to investing could have provided a greater return relative to some traditional benchmark exposures, even over a 10-year period,” Mehta says.

At Team LWC, Kerlow says they tend to use lightly leveraged ETFs with lower-volatility asset classes. They’re looking at adding lightly levered exposure to Canadian banks, which are a high-dividend, low-beta sector that tends to exhibit enhanced returns with the addition of modest leverage.

“Lightly leveraged ETFs have daily liquidity, so that allows us to use it inside of our unified managed account platform, which is the infrastructure we use to manage our core portfolios,” he says. “Used prudently as a small component of a portfolio, lightly levered ETFs could be applicable, even for clients that are looking for income as they can enhance the income generated from that sliver of the portfolio.”

Fees are a factor, but not a priority

Because leverage can bring unexpected risk to a portfolio when used inappropriately, Kerlow says they have more confidence in lightly leveraged index ETFs, where the use of leverage is more constrained compared to active strategies.

Horizons ETFs also launched the Horizons Equal Weight Banks Index ETF, which comes with a management fee of 0.09%. That makes it the lowest-cost Canadian bank ETF based on all publicly available data at the time it was launched. The firm said it would voluntarily rebate the ETF’s management fee, bringing its MER down to 0% until July 31, 2024.

Kerlow says fees are a consideration for him and his fellow portfolio managers at Team LWC. Higher up the list of priorities, though, is getting the exposure they’re looking for and, when applicable, the degree of leverage being applied.

“The leverage is coming from borrowing that’s influenced by interest rates, which are a drag on performance,” he says. “If you think about the leverage being used, even if it was risk-free, it's almost 500 basis points higher now than it would have been a little over a year ago. That easily surpasses the comparison of a manager that's charging 40 [basis points] versus 30.”