Why even large investors get burned with leveraged ETFs

Research indicates institutions seeking diversification and tactical benefits instead tended to outperform

Why even large investors get burned with leveraged ETFs

Followers of the financial industry know full well that institutional investors, those with hundreds of millions in investable assets to deploy into investment strategies both rarefied and pedestrian, are often called the “smart money.” But new academic research coming from the U.S. suggests that, when it comes to leveraged ETFs, that label fits some better than others.

In an analysis of 6,467 institutions that manage over $100 million in long positions, researchers from Clemson University, Colorado State University, and the University of Toledo found that including leveraged ETFs in an institutional portfolio has an overall detrimental effect on performance, reported Institutional Investor.

From 2006 until 2011, the proponents of the study found that the proportion of institutions with leveraged ETF holdings rose from less than 1% to 12%. Institutional participation in the leveraged ETF market, meanwhile, rose from 3.2% to 31.1% during the five-year period ended in June 2013.

A deeper dive into revealed that leveraged were most likely to be present among certain types of institutions, such as “transient institutions,” any fund with high portfolio turnover, and “quasi-indexers,” hybrids of index-trackers and active managers, rather than the more white-shoe likes of pension funds, endowments, insurance companies.

While there was significant appetite for the instruments, the authors asserted that they were “best suited for sophisticated institutional investors, and may be potentially costly for unsophisticated investors.” The correlation between leveraged ETF holdings and institutional underperformance was observed among those that are “likely to lack skills” – presumably with respect to execution and market timing ability, for example – as opposed to institutions with “potentially good skills,” where leveraged ETF exposure had no impact on performance.

The study recognized that skilled institutions could extract additional value from dynamic strategies with leveraged ETFs, but leave less-sophisticated institutional portfolios exposed to unintended or excessive risks that may diminish portfolio returns.

“If a particular institution holds these products, then you can tell that… this institution is going to perform worse relative to its peers in the future,” Kainan Wang of the University of Toledo, one of the study’s authors, told Institutional Investor. “I think policymakers should be considering lev ETFs as a bad product.”


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