Canadian Securities Course (CSC) Level 2 Practice Exam

What is a significant risk associated with Leverage Exchange Traded Funds (ETFs) due to their investment strategy?

1. Decreased market exposure

2. Higher counterparty risk

3. Path-dependent returns

4. Increased capital gains

The correct answer is: Higher counterparty risk

Leverage Exchange Traded Funds (ETFs) utilize financial derivatives and debt to amplify the returns on an underlying index. One significant risk associated with this strategy is path-dependent returns. This refers to the variability of returns that can arise based on the sequence of price movements over time, leading to outcomes that can differ from what investors may expect when they think about the fund's leverage level. In the context of leveraged ETFs, if the market experiences volatility, the daily rebalancing of these funds can lead to greater losses or smaller gains than anticipated, depending on the market's movements. Statistically, this can potentially hurt long-term performance when compared to a non-leveraged counterpart, especially in fluctuating markets. While higher counterparty risk is a consideration in certain financial products, it is not the primary concern specifically linked to leveraged ETFs. Similarly, decreased market exposure and increased capital gains do not capture the essence of the risk inherent in the leveraged investment strategy. Therefore, understanding the path-dependent nature of returns is crucial for comprehending the unique risks that leveraged ETFs present.