The promise and perils of geared ETFs
Geared ETFs are designed to be used by speculators who are making short-term bets on the direction of the market. I’m more invested in the case for geared ETFs for investors. Even if they are not designed to be held over the long-term many investors take that approach. Investors who own geared ETFs often explain their decision to me using the same logic. Over the long-term the share market always goes up so why not amplify that return.
A good place to start is a simple definition of a geared ETF. Geared ETFs amplify returns on the assets held in the ETF. If the underlying assets held in the ETF go up in price the ETF’s return will go up more. The same thing happens if the underlying assets in the ETF go down in price. The ETF’s return will go down more. Seems simple enough. But like everything in investing the devil is in the details.
What options do investors have for geared ETFs
I outlined the basic idea behind a geared ETF in the opening section. The basic premise that a geared ETF amplifies returns is expressed very differently in the investment offerings available in Australia. At a high level these differences are in both the degree of return amplification and the ways in which this amplification is achieved.
For example, BetaShares has introduced their Wealth Builder series of ETFs which seek to amplify returns between 30% to 40%. One of the ETFs in this line of offerings is the Betashares Wealth Builder Australia 200 Geared (30-40% LVR) Complex ETF G200. This ETF takes another BetaShares ETF which tracks the ASX 200 and applies gearing by borrowing money.
At the other end of the spectrum is the Ultra Long Nasdaq 100 Complex ETF LNAS. In this case the ETF seeks to amplify returns by 200% to 275%. The underlying exposure is the NASDAQ-100 index and derivatives are used to apply the gearing.
These are only two of the many options available for Australian investors. I will explore them in more detail but if you are considering a geared ETF start by concentrating on the index that is being tracked and the amount of gearing that is applied.
Why this might not be the best approach for long-term investors
Over single day periods a geared ETF should deliver the returns that investors seek. For example, if a geared ASX 200 ETF is looking to provide 2x the index returns and the ASX 200 goes up 5% an investor can expect the ETF to deliver a return of 10%. That is why I stressed that they are designed for day traders.
Over longer time periods the ETF will not deliver those returns. To understand why we need to take a step back and look at the underlying math of returns. Here is a scenario that confuses many investors which demonstrates how the math works:
- One day the ASX 200 goes down 5%.
- The next day the ASX 200 goes up 5%.
What is the return? Most investors would reflexively say the return is flat. The fall on the first day is reversed by an equal gain the next day. This isn’t true. Lets assume the index value is 1000 before our two days of results.
- One day the ASX 200 goes down 5% which means the index falls from 1000 to 950 ((1000 x (1+ -.05)).
- The next day the ASX 200 goes up 5% which means the index goes from 950 to 997.50 ((950 x (1+.05))
The overall return over that two-day period is -.25%. This isn’t a huge difference. But it is a difference. This is compounding in a nutshell. In my example I used a positive and negative return to illustrate compounding but if I used a two-day period when the ASX 200 went up 5% each day the return would not be 10% – it would be 10.25%. In markets that mostly go up over the long-term this is the impact of earning a return on your return or…..compounding.
The problem with a geared ETF is that the gearing is designed to work over a one-day period. Over a longer period the return is distorted by the day-to-day volatility of the market.
I am going to use a different ETF issued by BetaShares because it was first released in April 2014 and there is a longer performance history. The BetaShares Geared Australian Equity Fund GEAR is designed to amplify the ASX 200 returns by 50% to 65%.
Since GEAR’s inception the ASX 200 has delivered returns of 8.40% per year. Many investors who don’t understand how geared ETFs work would expect returns between 12.60% and 13.86%. Instead, GEAR achieved returns of 11.08% a year.
This is meaningfully lower than what you might expect given the amount of gearing. But it is still a good deal higher than the underlying index. This is neither good nor bad. It all depends on what you are trying to accomplish and your understanding of the how each investment you consider works.
The way each ETF performs in comparison to the underlying index is based on the amount of gearing involved, the size of the gains of the index and the volatility of the index. We can see these impacts on a scenario that isn’t as positive as earning a higher return that falls short of what some investors might think.
We can use the Ultra Long Nasdaq 100 Complex ETF LNAS. This is the ETF that seeks to amplify returns on the Nasdaq 100 by 200% to 275%.
Over the past three years the annual return of LNAS is -0.37%. The Nasdaq 100 index returns were 13.62% a year. Both returns are in Aussie dollars. We can explore year to date, 2023 and 2022 returns of LNAS and NDQ which tracks the Nasdaq 100.
The geared ETF did terribly in 2022. It performed ~250% worse than the overall performance of the Nasdaq 100. This was a tough year for the Nasdaq 100 and volatility was higher than normal. We can also see the differences between the implied gearing levels and the longer term return amplification achieved in the annual periods.
To understand why this occurred we can look at how volatility and the degree of gearing impacts an ETF like LNAS. In this first scenario we can explore an index that goes up 1% every day for 10 days. This is a very positive scenario for a geared ETF where the more gearing employed the better an investor will do.
In this scenario the ETF will do better than the gearing implies. Now we can simulate a scenario where there is lots of volatility. Over a 10-day period the index alternates between 2% losses and 3% gains.
In this scenario the ETF does worse than the gearing would imply. This is only a 10-day scenario. Long periods of volatility mean that the geared ETF will perform very differently than most investors would assume at first glance.
Final thoughts
Before considering the introduction of gearing into your portfolio it is worth taking a step back and looking at your holistic financial situation. If you own a home with a significant mortgage you have already introduced a good deal of gearing into your finances.
Technically the gearing you’ve taken on is not directly applied to your portfolio. But in a practical sense you are getting the same impact since any money you’ve invested could have been applied to your mortgage.
If you still want to apply gearing to your portfolio consider the different ways you can do it. Taking out a margin loan in your brokerage account is one option. There are plusses and minus to this approach and it does introduce a good deal of risk. However, the amplification of returns – and losses – will be cleaner. You will get exactly what you expect in any market scenario.
For anyone that is considering a geared ETF always remember that they are designed for day traders and may not be right for a long-term investor. Some times simplicity works best and just capturing the long-run market return is enough to help most investors achieve their goals.
I would love to hear your thoughts on how you use gearing in your portfolio. Email me at [email protected].