To Leverage or Not to Leverage: A Primer for Canadian Investors

It probably seems straightforward—if investing in the S&P 500 index is a good idea, then surely investing in 1.5x, 2x, or even 3x the performance of the S&P 500 must be even better, right? Not so fast.

This approach is known as leveraging, and while it can indeed be a powerful tool to magnify your returns, it can also swiftly land you in the poorhouse. Margin is a double-edged sword!

Today, if you're interested in leveraging, it's never been easier to get involved; you don't even need to open a margin account. Canadian investors can simply purchase leveraged ETFs directly within tax-advantaged accounts like the TFSA or even the FHSA— (got to keep pace with soaring house prices, eh?).

However, the world of leveraged ETFs involves more than just high returns; there's a significant amount of technicality involved. Here's my survivor’s guide on how these ETFs work and how to strategically use them in your investment strategy.

Leveraged ETFs: the daily variety

We'll start with a look at the BetaPro S&P 500 2x Daily Bull ETF (HSU) from Global X Canada (formerly Horizons ETFs). The objective of this ETF is straightforward—it aims to deliver daily returns that are two times that of the S&P 500, hedged to the Canadian dollar.

Here's where the technicalities come into play: HSU's leverage is calibrated to be accurate on a daily basis. This means if the S&P 500 rises by 1% in a day, HSU is designed to rise by 2%. However, there's no guarantee that if the S&P 500 rises by 5% over a week, HSU will rise by 10%.

This discrepancy can arise due to the effects of compounding and high volatility over longer periods. For a deeper dive into why these discrepancies occur, I recommend checking out an article by a quant over at Double-Digit Numerics who explains this phenomenon well.

Therefore, HSU is better utilized as a short-term day trading tool rather than a long-term holding. Why? Let's look at the long-term backtest of HSU versus the Vanguard S&P 500 Index ETF (CAD-Hedged) (VSP) from November 8, 2012, to July 26, 2024.

During this period, HSU returned 21.66%, which is not exactly two times the return of VSP, which was 13.35%. Remember, the leverage target of HSU is only precise within a single day, not over the long term. The higher 1.54% MER (Management Expense Ratio) of HSU certainly didn’t help its case either.

Moreover, the volatility of HSU was significantly higher, with a standard deviation of 33.51% compared to 16.74% for VSP. Essentially, HSU offered less than double the return of VSP but with more than double the volatility—a poor risk-return trade-off. The lower Sharpe ratio of HSU at 0.55 versus 0.67 for VSP further illustrates this point.

Additionally, holding HSU would have also meant dealing with a maximum drawdown of 59.73%, a much steeper peak-to-trough loss compared to VSP at 35.55%. Not many investors can handle such volatility without feeling the urge to sell at a loss.

In short, while daily resetting leveraged ETFs like HSU can be advantageous for trading and short-term positions, they are far less ideal for long-term investment strategies.

Leveraged ETFs: the new breed

To cater to Canadian investors hungry for a more sustainable leverage option suitable for long-term buy-and-hold strategies, fund managers like Global X ETFs have introduced innovative products. A standout in this new breed of leveraged ETFs is the Global X Enhanced S&P 500 Index ETF (USSL).

This ETF takes a unique approach by simply borrowing up to 25% of its assets to achieve 1.25x leverage, and it invests this borrowed money into another Global X S&P 500 ETF. This method of leveraging is distinct from leveraged ETFs like HSU, which typically use derivatives such as swaps.

USSL's strategy is akin to using a margin account, but with one significant advantage—Global X accesses institutional borrowing rates, which are typically much lower than the rates individual investors might find at retail brokerages like Questrade.

These newer ETFs like USSL can indeed be held for the long term, but they still require cautious consideration due to their leveraged nature. Leveraging equities at 1.25x, or 125% exposure, inherently amplifies volatility. If you're not comfortable with the risks associated with at least 100% equity exposure or if you don't have a long investment horizon, then this ETF might not be appropriate for your portfolio.

Currently, the management fee for USSL is set at 0.35%, but I expect the total expense ratio (MER) to hover around 2% when accounting for the interest expenses from borrowing. It’s important to note that as interest rates fluctuate, so too will the cost associated with this leveraged approach.

USSL isn’t the only product in Global X's lineup that utilizes a 1.25x leverage strategy. The firm also offers similar options for global equities, Canadian equities via the S&P/TSX 60, and the Nasdaq-100, expanding the choices available for investors looking to employ a moderate level of leverage over longer periods.