The Million Dollar Journey had an article yesterday about Horizons BetaPro ETFs. These Exchange-Traded Funds (ETFs) are designed to give investors double exposure to certain indexes.
This means that if you are invested in their S&P/TSX 60 ETF and the index goes up by 1% one day, the ETF should go up by 2%. They also offer a bear version of each ETF where a 1% rise in the index gives a 2% drop in the bear ETF. Obviously, the owners of the bear ETFs are hoping for the index to drop.
Let’s focus on the ETF based on the S&P/TSX 60 index, which is based on the biggest companies in Canada. If the TSX 60 goes up by 10% one year, you’d expect the corresponding Horizons BetaPro ETF (ticker symbol HXU) to go up by 20% that year. But, that’s not how it works. For example, this fact sheet shows that in its first year, HXU returned 13.28% and the TSX 60 rose 9.19%. If we double the TSX 60 return, we find that there is a 5.1% gap.
What causes this 5.1% gap? I tried reading the prospectus, but like most such documents, clarity doesn’t seem to have been a priority. Page 36 outlines a number of fees including 1.15% management fees, operating expenses, and various expenses attached to forward contracts.
In addition to fees, the method used to achieve double exposure contributes to the 5.1% gap. This can be interest on borrowed money or built-in bias of stock options (called forward contracts in this case). When you trade in stock options, the expected rise of the underlying stock (the TSX 60 in this case) is built in to the option prices.
If this explanation of the 5.1% gap makes no sense to you, don’t worry. Just accept that it exists for what follows.
It might seem like we just need the TSX 60 to return at least 5.1%, and then HXU will perform better than the TSX 60. This works for one year, but doesn’t take into account the effect of volatility on long-term compounded returns.
Based on historical data, the long-term compounded return will be lower than the expected one-year return by about 2%. However, HXU’s doubled volatility increases this penalty by a factor of 4 to about 8% per year.
Combining all this together with the 5.1% gap we observed earlier, the TSX 60 would have to have a long-term compounded return of 9.1% for HXU to break even with the TSX 60. Suddenly, HXU doesn’t look as appealing as it did before.
(Math interlude that can be ignored: If the expected one-year return of the TSX 60 is x, then its long-term compounded return will be x-2%. HXU’s one-year return will be 2x-5.1%, and its long-term compounded return will be 2x-5.1%-8%. Equating the two compounded return gives x=11.1%, or a long-term compounded return for the TSX 60 of 9.1%.)
The bear versions of the ETFs are much easier to argue against. Investors and pundits cannot reliably predict when the stock market will drop. The bear ETF corresponding to HXU is HXD and it had a one-year return of -19.85%. An investor who chose the bear for this year would be in a very deep hole trying to catch up to investors who just bought the TSX 60.