Inverse And Leveraged ETFs

Two of the boom areas in the U.S. ETF market over the last couple of years have been the inverse and leveraged sectors. According to the latest Deutsche Bank "ETF Liquidity Trends" report (22 July 2008), during a recent trading week, short (inverse) ETFs generated the third-highest turnover levels after large-cap and equity sector ETFs. Leveraged ETFs ranked sixth. A fine example of short ETF activity of late is the ProShares UltraShort Financials ETF (AMEX: SKF), reporting an impressive $4.56 billion of trades in the week under review.

How do things stand in Europe, by comparison? It is worth remembering that Europe was responsible for the world's first inverse (and leveraged) ETF - the XACT bear fund in Sweden (Stockholm:XACT-BEAR.ST), launched in February 2005 while the SEC was still deliberating over authorising this type of fund.

On the face of it, Europe has lagged the U.S. market's development by some margin.

At the latest count—again using figures from the above-mentioned Deutsche Bank's report—there were 18 inverse and 18 leveraged ETFs in Europe, with around € 1.3 billion and € 0.8 billion under management, respectively. Combined, these ETFs represent about 2% of the overall European ETF market. In the U.S., by contrast and despite their late start, there are 45 short and 31 leveraged ETFs, with around $15 billion and $5.5 billion under management, respectively, adding up to more than 4% of the U.S. market.

So why the lag? And what are the prospects for this type of ETF in Europe? I spoke to some of the leading market participants to find out.

Claus Hein, executive director of Lyxor Asset Management—one of the major European ETF providers in both the leveraged and inverse sectors—pointed out that not all European managers are able to offer this type of fund, which requires synthetic replication capabilities (the use of swaps). In other words, those managers relying mainly on physical replication methods in structuring their funds have, so far, not entered the sector. Of course, we see a similar situation in the U.S., where many leading players have stayed away from inverse and leveraged ETFs, leaving the field to what are otherwise niche providers—namely, ProShares and Rydex.

Francois Millet, head of distribution for SGAM in Paris, added that retail investor involvement in the European ETF market continues to lag that of leveraged and leveraged-inverse ETFs in the U.S., particularly those on equity market sectors. The relative lack of European retail investor interest, according to Millet, is a function of familiar structural inefficiencies: the continuing prevalence in Europe of commission- based financial advisors, for a start, who, as we know, are reluctant to recommend ETFs, as they receive no share of management fees.

There are other differences between the European and U.S. market in terms of product range, said Millet. In particular, the warrants and certificates markets have been popular for a number of years with retail investors in France and Germany as a way of generating inverse and/or leveraged exposure on equity market indices, and ETFs have to compete with these products. Add to this single stock futures, contracts for difference in the U.K. (which trade tax-free) and futures themselves, and it is clear that there is now a wide range of choices for European investors who want to trade markets short as well as long.

As far as the relative popularity of long and short ETFs on the same indices is concerned, it's difficult to draw general conclusions. It's interesting to look at assets under management (AUM) figures due to the fact that one of the most popular types of ETF trading strategies in the U.S. market has been switching between long and short (or double-long and double-short) versions of an equity index or sector index ETF—between the 200% and -200% S&P 500, QQQQ, or financials ETFs, for example. The significant AUM levels in all these funds are a testament to the number of investors involved. Is anything similar going on in Europe?

I looked at fund flows for two long and two short db x-trackers funds - the long and short Dax (XETRA:DBXD.DE, DXSN.DE) and EURO STOXX 50 (XETRA:DBXE.DE, DXSP.DE) ETFs. I chose these because the short versions of these ETFs are currently the largest inverse funds in the European market. The AUM ratios between the two fund pairs over the last year or so are shown on the next page.

It seems that investors have preferred the long ETFs to the inverse versions for most of the last year, with the ratio substantially in favour of the longs for the EURO STOXX 50 funds. Manooj Mistry of db x-trackers pointed out to me that the inverse ETFs have tended to be used by European investors as a short-term tactical trading vehicle, whereas the long versions have had more stable holders, so making a direct comparison between the respective funds' sizes may not mean much.

However, if we look at leveraged long and short funds in Europe, taking, for example, the XACT bull and bear ETFs (Stockholm:XACT-BULL.ST, XACT-BEAR.ST)—with 150% and -150% leverage respectively—or the SGAM leveraged CAC 40 and XBear CAC 40 ETFs (Paris:L40.PA, BX4.PA)—with leverage of 200% and -200%—then in each case, the inverse versions currently have larger AUM than the long versions, according to the latest Deutsche Bank figures.* This, incidentally, ties in with current U.S. market experience for a number of leveraged and double-inverse fund pairs. While some analysts have used these AUM ratios as (contrarian) market sentiment indicators, at the very least, the size of the leveraged inverse ETFs shows how popular short-selling has become. Don't tell the SEC or the FSA!

What is next on the product development front in Europe? Bearing in mind that fund providers will wish to continue to apply the UCITS stamp to their ETFs, and that the UCITS rules allow leverage of up to 200% of NAV, there is clearly scope for further leveraged (and leveraged-short) ETFs to be launched.

SGAM's Francois Millet pointed out that European ETF product developers have been looking at ways of getting round the constant leverage problem, perhaps by launching fixed-maturity ETFs that could trade like futures.

There is an obvious gap to fill in equity sector long/short ETFs, an area which has been very popular in the U.S. but remains relatively underdeveloped in Europe, with only db x-trackers offering funds of this type.

And there are plenty of underlying asset classes that are still to be covered by inverse and leveraged ETFs. The commodities space already sees ETF Securities offering a wide range of products, but there are plenty of possibilities in fixed income, for example.

So, in summary, while the leveraged and inverse ETF sector in Europe has developed less quickly than in the U.S., it is still an area of dynamic product development and increasing investor demand. We can expect more firms to become involved and further innovation from the main ETF market players.

Paul Amery is the European correspondent for IndexUniverse.com. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .