• We will borrow the British expression for leverage - gearing - to refer to levered, inverse and/or levered-inverse exchange-traded tracking products¹ (ETPs). First, by using the expression "geared" we are attempting to refer to this group of ETPs - +3x, +2x, -1x, -2x and -3x exposure² - in a more succinct manner. Let us hope that the gearing magnitudes do not increase any further (4x)! Second, we would like to differentiate between the leverage used by ETPs to magnify and/or invert a desired exposure, and the leverage used by closed-end funds to enhance their distribution rate. The first modifies the exposure, the second modifies the distribution.³

• The market has embraced geared ETPs as measured by the growth in the assets that these tools have gathered in a relatively short period.

• Too many users of geared ETPs do not fully appreciate the effect that excessive volatility has on their return. Many blame the tool, but we would argue that it is often the user who is not skilled enough. A trending market - a low volatility relative to return - could produce satisfactory returns, while a trendless index with excessive volatility is likely to produce substantial losses. A real example will help us illustrate the impact of volatility on the return of a geared ETP.

• Geared ETPs may not be as tax-efficient as ETPs that track indices of stocks and bonds because they cannot take advantage of the tax-efficiency resulting from the creation/redemption process.

• Geared ETPs are more likely to carry counterparty risk, which is non-existent in current U.S.-traded exchange-traded funds (ETFs) that track the simple exposure - one time beta - of stock and bond indices by holding the underlying securities.

• We think geared ETPs are appropriate only for speculative investors and short-term traders who are truly familiar with all the moving parts that affect the total return of a geared ETP.

ASSET GROWTH

In the last few years, geared ETPs have expanded the arsenal of tools that allow market players to confront the markets. The market has certainly embraced these relatively new tools quickly and broadly as evidenced by the rate of growth in assets in those types of products. Since the first geared ETP was launched in the summer of 2006, there are currently $30 billion in more than 120 geared ETPs. The assets in geared ETPs have risen as the markets declined last year.

Players

The first mover's advantage is usually quite strong in the ETP universe. Thus, it is not too surprising that ProShares, the first to launch geared ETPs, currently holds over 80% of the assets in geared ETPs. It is surprising though, that Direxion, the newest entrant in this universe after launching its first geared ETP as recently as early November, has quickly ramped up to be the number two player as measured by assets. Direxion holds over 10% of the assets in geared ETPs. One may argue that one of the reasons why Direxion gathered so many assets in such a short period, is because Direxion also had a first mover's advantage - Direxion gears its ETPs three times, as opposed to only two times. At this point, no other geared ETP provider does that.

Some of the other players that offer geared ETPs are PowerShares/Deutsche Bank (5% of assets), Rydex (1%) as well as Morgan Stanley and UBS.

Gearing Magnitude

It appears that when market players employ geared ETPs, particularly when they have a view against the market, they are quite confident about their "bet." That would explain why many more assets are held in geared ETPs that provide -2x exposure (46% of total geared ETP assets) compared to those with -1x exposure (only 6%), as shown in the pie chart below.

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