The horrible freeze on launching any financial products that are remotely different or new is finally coming to an end – and some tentative green shoots of innovation are budding.
Last week, two index tracker ranges emerged on the London market – one with some fanfare, the other attracting far less attention.
ETF Securities’ launch of a fairly comprehensive range of leveraged exchange traded funds (ETFs) – covering everything from the FTSE 100 to the Dax – has provoked lots of interest and a fairly unprecedented £20m inflow of funds in just one week!
Readers of my column will recognise these products as I have been lobbying for their introduction for nearly a year. ETF Securities is offering two times the daily returns of the underlying index, with both bull and bear versions – ie, the bull versions return two times any gains, the bear versions two times any losses.
These products are hugely successful in the US. Another provider, Direxion, first launched them, closely followed by Proshares – but not without controversy. Direxion had to flood its website with warnings and caveats – and brokers have reported disgruntled investors who reckon they’ve been cheated by the daily return profile.
The regulators have also pitched in with some heavy-duty warnings, as reported in FTfm on June 28.
ETF Securities’ range is plain vanilla, transparent, heavily collateralised and based on low expense ratios compared with other products.
But before you think you’ve found the perfect geared way of playing the market, you need to understand what you are getting into. The key words are “daily returns”. They are hugely important because these ETFs simply return twice the daily total price return of the underlying index. If the index goes up 10 per cent, your bull trackers return 20 per cent in that day, and the bear trackers lose 20 per cent. But in volatile, choppy markets – rather like today’s – the power of compounding losses really kicks in.
To understand this point, look at a sample one-year return to June 17 2009. Over this period, the FTSE 100 returned a loss of 27 per cent. Based on daily returns, the bull tracker would have produced a loss of 52 per cent – pretty much what you’d expect. But the bear tracker would only have given a return of 13 per cent – not the 54 per cent gain you might have thought you’d receive.
Why? Because when the market moves against your leveraged position, the compounded effect of those negative moves starts to add up – and the recent rally has given us some big daily gains that have crushed returns for the bear fund, even though the market is substantially down in overall terms.
As with any leveraged product, the trend is your friend but volatility and sideways moves are your enemy. If the market rises in a straight line over a fixed period, the bull trackers will deliver big profits. If the trend is weak, your returns will be hit.
Still, these products will appeal to day traders, although they can get much bigger leverage elsewhere using covered warrants and spread bets (at much greater cost). These ETFs might also interest adventurous investors looking to capture key trends. For example, if you think the FTSE 100 will move up sharply for a few months, you should take a close look at the FTSE 100 bull funds.
If, instead, you want a much simpler one-to-one bet on the markets moving downwards in a choppy way, look at Deutsche Bank’s db x-tracker Short FTSE 100 ETF.
SocGen launched the other product that caught my eye. It has created a tracker range that gives investors access to the FTSE 100 dividend swaps market. The SocGen listed trackers give investors a chance to play both the 2010 and 2013 dividend market by taking a simple one-to-one long position. Here’s how they work. The “FTSE 100 2013 implied dividend” price per certificate was £146, implying £146 worth of dividends for each FTSE 100 bundle of shares, on the basis that the bundle is worth the index level in pounds: £4,300 at time of writing.
That implies a dividend yield of 3.3 per cent out to 2013, which even I think is a bit cautious. Many analysts think that an economic recovery will boost dividend payments and that the yield for the FTSE 100 might shoot back up to trend at between 4 and 4.5 per cent (no-one believes the current level of 4.74 per cent as a basis for forecasting).
Let’s say the optimists are right and the market pays out 4 per cent. Based on the current price of £4,300, you’d be looking to make £172 in actual, as opposed to estimated, dividends. That’s an increase of around 20 per cent over the current price. But you would also expect the FTSE 100 to increase in value to perhaps 5,500. So, assuming a 4 per cent yield, your bundle of dividend payments would have increased to £220, giving you a nice profit.
Two words of warning: I’d be very cautious about the estimate for dividends on the short-dated products, and the longer-
dated certificates are based on a much more illiquid market where estimates can be notoriously vague.
