An increasing number of institutional investors are using leveraged exchange-traded funds in their portfolios — even though research suggests that many lack the skills and market timing ability to take advantage of them.

While leveraged ETFs may seem like an attractive way to diversify portfolios or implement strategic bets, the presence of these products in institutional portfolios has had an overall adverse effect on performance, according to a study from Luke DeVault of Clemson University, H.J. Turtle of Colorado State University, and Kainan Wang of the University of Toledo.

“If a particular institution holds these products, then you can tell that… this institution is going to perform worse relative to its peers in the future,” Wang said in an interview with Institutional Investor. 

Looking at a sample of 6,467 institutions that manage over $100 million in long positions, Wang and his co-authors found that the proportion of institutions holding a leveraged ETF grew from less than 1 percent in 2006 to 12 percent in 2011. By June 2013, they found that institutional participation in the leveraged ETF market amounted to 31.1 percent, up from 3.2 percent five years earlier.

The institutions holding leveraged ETFs tended underperform when compared to those not holding them — poor performance that the researchers attributed to “poor market timing ability.” DeVault, Turtle, and Wang further found that after good past performance, managers appeared to reduce positions in leveraged ETFs. 

Leveraged ETFs Are a “Bad Product”

Calling leveraged ETFs an “especially risky investment,” the researchers suggested that these investments are “best suited for sophisticated institutional investors, and may be potentially costly for unsophisticated investors.” In fact, they found that institutional underperformance could only be linked to leveraged ETF holdings when the institutions are “likely to lack skills.” For institutions with “potentially good skills,” leveraged ETFs had no impact on performance. 

“For skilled institutions, leveraged ETFs could provide additional value within dynamic strategies,” the study said. “In contrast, leveraged ETF holdings within less-sophisticated institutional portfolios may expose institutions to unintended, or excessive risks, and may result in diminished portfolio returns.” 

While leveraged ETFs have become more popular, they haven’t caught on across all types of institutional investors. Endowments, public pension funds, and insurance companies didn’t appear to invest in these assets, researchers said. Instead, “transient institutions,” defined as any fund with high portfolio turnover, and “quasi-indexers,” hybrids of indexing trackers and active managers, were among the most likely to report leveraged ETF holdings. 

According to Wang, the study comes at a time of increased debate and conflicting public policy surrounding leveraged ETFs.

“I think policymakers should be considering lev ETFs as a bad product,” he said. “Because even the most sophisticated investors out there, like institutional investors, cannot successfully do well in these products.”