To The Moon

Since Exchange-Traded Products (ETPs) which go beyond the “traditional” Exchange-Traded Funds (ETFs) were introduced to investors, it should be intuitively evident that each of these products is essentially a “packaged” trading strategy that brings two useful features to the holder:

1. Leverage on either the upside or downside of the underlying instrument’s price trajectory;

2. Scalability by being several orders cheaper relative to the underlying, thus giving greater flexibility to the holder.

On the matter of leverage, however, ETPs have not been an innovator. A number of products and services already available via banks and brokerages exist that compete with ETPs in this space. Chief among them are Daily Leverage Certificates (also known as “Factor Certificates” or “Constant Leverage Certificates” in Europe) and Contract for Differences (CFDs). Daily Leverage Certificates have proven to be particularly popular among sophisticated investors while CFDs find favour among high-net-worth investors and speculators. In comparison to these, however, ETPs offer a number of significant advantages (and possibly some limitations).

ETPs vs Factor Certificates/Daily Leverage Certificates

The terminology used to “define” the ETP is quite similar to that of Factor Certificates available to retail investors and for good reason: a 3X Tesla Short ETP ostensibly delivers the same benefit as a 3X Tesla Short Factor Certificate. However, the application of fees is an entirely different matter.

Let’s consider an example to illustrate this: the Tesla ($Tesla Motors(TSLA)$ ) 3x Short Factor Certificate issued by Goldman Sachs (ISIN: DE000GX2YWR8 | WKN: GX2YWR). The Key Information Document is as follows:

This instrument, traded on the German bourses, is quite typical of the Factor Certificates available in the marketplace. The fee structure indicated is also fairly typical, with some variation in percentages. As is evident, the fee structure is rather complex. Going by the composition, the holder initiating the investment is required to pay the issuer (i.e. Goldman Sachs) at least 4.40% of the resultant investment’s growth as fees over the course of a year. This amount doesn’t include any other fees from the wealth manager, brokerage, margin fees, etc. Converting on a daily basis, this constitutes a “payout” of at least 0.01% of the investment’s value each day. However, after factoring in the one-off costs, the effective cost impact on any given day for this product is around 5% of the product’s performance!

In contrast, the Leverage Shares -3X Short Tesla ETP ( $-3X TSLA(TS3S.UK)$ ; ISIN: XS2337090265) pays the holder a fee of 10.48% over the course of one year, which translates to a fee of 0.03% on a daily basis. Hence, if it is assumed that the product does not make any gains/losses over the course of a year and interest rate conditions remain constant, an investor would make 10.48% simply from holding the product.

Note: In either case, the holder neither pays nor receives the cost/fee at any point of time. It is “baked” into the product, i.e. the final price seen on the trading screen already factors in the fee payable on a continuous basis. Thus, in the aforementioned scenario, even if the product doesn’t appreciate in its performance throughout the course of the year, its fee structure ensures that its price appreciates by 10.48%.

The reason why the ETP is so interestingly priced is a function of the formulation used for the computation of costs. The formulation is built around the Effective Fed Fund Rates (EFFR) which is quite high right now. Generally speaking: when the EFFR trends higher, the formulation structure by Leverage Shares ensure that the fees for the short ETPs trend lower. On the other hand, the Factor Certificates are financially-engineered products with a variety of scenarios modelled to protect the issuer’s liability and implied cost of capital.

A close counterpart to the Factor Certificates of Europe would be the Daily Leverage Certificates (DLCs) of Singapore, which find a lot of favour among the speculative market players of the region. For example, one such DLC would be the 5X Alibaba ( $Alibaba(BABA)$ ) Short DLC (ISIN: LU2375049413) issued by Société Générale.

The reason why it’s considered a “close counterpart” is evident from the statements on the fee structure: while the management fee and the gap premium together only add up to 0.02% on a daily basis, hedging costs, rebalance costs, et al bring the cost of this instrument to at least 0.12% on a daily basis.

In contrast, the Leverage Shares -3X Short Alibaba ETP ($LS -3X SHORT ALIBABA (BABA) ETP(SBA3.UK)$ , ISIN: XS2472334585) pays the holder an annual rate of 9.82%, which translates to a daily rate of a little under 0.03% receivable by the holder.

In a similar vein, let’s consider the 5X Alibaba Long DLC (ISIN: LU2348854998) by the same issuer:

The stated fee structure ensures a cost of at least 0.15% is incumbent on the holder’s investment performance on a daily basis. On the other hand, the Leverage Shares 3X Alibaba Long ETP ($3X BABA(3BBE.UK)$ ; ISIN: XS2337090851) effectively charges the holder a daily rate of a little under 0.03%.

As before, the disparity in fee levels is also based on the formulation of costs: the DLC is an intricate financially-engineered instrument while the ETP is built upon the Effective Fed Funds Rate prevalent at any time.

One more aspect that should be borne in mind with financially-engineered products such as Factor Certificates and DLCs is their time to expiry. Most Factor Certificates (and Daily Leveraged Certificates) are designed with a “Expiry Date”, i.e., on a certain day in the near future, these instrument would cease to exist and the holder will have to settle with the issuer at the DLC’s fair intrinsic value that is determined on its “Valuation Date”, which is usually one business day before the stated Expiry Date. After expiry, the holder can choose to re-invest in another engineered product with the same underlying, if they wish to continue to bet on the underlying and if such an instrument is available at the time.

Technically, ETPs generally have no expiry date. Some jurisdictions necessarily require a date in which event a date is included (and subsequently extended). An ETP would generally be delisted only if the Net Asset Value approaches US$0. In such an event, the holder would receive the delisting price for their investment.

ETPs vs CFDs

Not every ticker is represented in the form of a Certificate (be it DLC or Factor Certificate) nor are Certificates available in every region. In either event, brokerages are known to step in with a type of arrangement known as “Contract for Differences” (or simply CFDs). For a certain class of investor, the brokerage would essentially structure a deal with specific costs that could widely from investor to investor.

Like Certificates, there is no single universal template for costs that brokerages follow. For example, eToro simply states the following schedule of fees:

The 0.15% fee is applied on a daily basis while the “annual fees” are based on the European Short Term Rate (ESTR). For instance, given that the ESTR is currently at a little under 2.4%:

A short position would attract an annual fee of 5.3% which, in conjunction with the “spread”, adds up to a charge of 0.16% on a daily basis. Of course, with increased leverage, comes increasing fees. As the examples with the Certificates indicate, this is at least 10 times greater than the packaged solution available as an ETP.

Another important point to note is that, unlike ETPs and Daily Leverage Certificates, a CFD’s leverage ratio is not rebalanced on a daily basis. Also, unlike ETPs and Daily Leverage Certificates, a CFD is not traded in the market. Instead, the counterparty is the brokerage itself.

Key Takeaways

When it comes to complex products such as CFDs, Daily Leverage Certificates/Factor Certificates (DLCs) and ETPs, there are some key elements wherein ETPs prevail overall relative to the other two instrument types:

However, on the matter of fees, it bears noting that not all ETPs are constructed the same way. In the examination done for this article, only the fee structure of Leverage Shares’ products was examined. Therefore, reading the Key Information Document, staying abreast of issuer announcements regarding fees, et al, is particularly important for novice investors not used to this space.

All in all, adopting an instrument with a higher fee structure when another with a lower fee structure is available essentially means money left on the table. Also, the risk profiles tend to be rather different. Going with ETPs could often lead to significant cost savings as long as one is cognizant of risks that are typically inherent in every type of complex product.

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