Risks continued to ease in the fourth quarter of 2012, on the heels of a sharp drop in the third quarter, with no signs of a reversal ahead, according to the latest Axioma Insight Quarterly Risk Review.

Leveraged ETFs provide geared exposure to markets.

Melissa Brown, Senior Director of Applied Research at Axioma and co-author of the review, said: “The decline in risk should give investors the opportunity to focus on achieving active returns, rather than fretting over common themes that affect all stocks.”

Among the highlights of Axioma’s latest risk report was a continued decrease in risk (as measured by predicted volatility) for European benchmarks, with medium-horizon risk for the eurozone crisis countries within the FTSE Developed Europe Index  – Greece, Spain, Italy, Portugal and Ireland – falling nine percentage points.

Medium-horizon risk for the US large-cap Russell 1000 and small-cap Russell 2000 indices also dropped in the fourth quarter.  Forecast risk for large-cap US stocks was on par with that of the FTSE Emerging Index, in sharp contrast with the fourth quarter of 2011 when the Russell 1000 was well below the Emerging index. Short- and medium-horizon risk forecasts also fell substantially for the FTSE Asia-Pacific ex-Japan Index.

With risk considerably reduced from recent peaks and close to a five-year low (and forecast to remain so), now could be the time for more risk tolerant, sophisticated active investors to consider tactically adding a degree of leverage to their portfolios. This can be achieved via leveraged exchange-traded funds (ETFs) and exchange-traded products (ETPs), which provide geared exposure to many of the world’s leading indices.

European ETP providers active in this space include Amundi, Boost, ComStage, db X-trackers, EasyETF, ETF Securities, Lyxor, RBS and Xact, offering an array of double and triple-leveraged products (as well as short/inverse counterparts) on a range of major equity, fixed income, commodity and currency indices. In the US, ProShares, Direxion, iPath and PowerShares lead the way, while in Canada, Horizons rules the leveraged roost.

Investors need to be careful when using these products, as leverage can accentuate loses as well as gains, but when deployed appropriately (and this depends on individual circumstances) leveraged ETPs can be highly effective and are a welcome addition to investors’ weaponry.

For example, an investor fully-invested (zero spare cash) in Europe may wish to add leverage via products such as the Amundi ETF Leveraged EURO STOXX 50 Daily or RBS Market Access EURO STOXX 50 Monthly Leverage Index ETF, which each offer 2x exposure to the EURO STOXX 50 Index and charge 0.30% pa. As an example, investors looking to leverage up to 125% exposure (25% leverage) might take out 25% from their unleveraged portfolio and add an equivalent position in one of these leveraged products, thus taking portfolio exposure to 125%.

Similarly, this level of exposure (125%) could be achieved via a 3x leveraged product, such as the Boost EURO STOXX 50 3x Leverage Daily ETP, by reducing the unleveraged portfolio by 12.5% and adding that amount to a 3x leveraged product. While this may result in less portfolio disruption (the leverage is less capital intensive), investors will likely incur a higher management fee (this particular Boost product costs 0.75% pa); it is important, therefore, to weigh up all the costs (management fees, trading commissions, tax and swap fees) when using these products.

Investors with surplus cash in their portfolio (known as ‘dry powder’) could use this to leverage up rather than temporarily disposing of core positions. For example, a 5% cash position could be leveraged up three times to generate additional exposure of 15%, taking a 95% invested portfolio up to 110%.

Of course, not everyone is in a position to take on too much extra risk. Therefore, investors reluctant to take on additional unhedged exposure, but wishing to exploit perceived ‘alpha’ opportunities within certain sectors or markets, could offset a leveraged long position with an equivalent short position.

For instance, to create a 120/20 portfolio – that is 120% long, 20% short, net 100% – a hypothetical investor fully-invested in the MSCI Europe ex UK Index (e.g. via say the iShares MSCI Europe ex-UK ETF) could reduce their unleveraged long portfolio by 25%, thus freeing up 25% of cash. 10% could be invested in a double-leveraged inverse ETP (e.g. db X-trackers ShortDAX x2 Daily UCITS ETF) to create the 20% short sleeve, while the remaining 15% could be invested in a triple-leveraged long ETP (e.g. Boost FTSE 100 3x Leverage Daily ETP) to create the leveraged 20% sleeve and refill the 25% long taken out. An investor executing this kind of portfolio structure would be bullish on Europe, bullish on UK large-caps (FTSE 100), bearish on German large-caps (DAX), but broadly neutral/positive on the overall developed pan-European market (i.e. net 100% exposure, no net leverage).

This article is merely designed to stimulate ideas and demonstrate some of the potential uses of leveraged long and short ETPs. Investors should unequivocally seek qualified professional advice before deploying these kinds of strategies.

Furthermore, there are other issues to consider such as volatility and beta with regard to hedging; capital inefficiencies with regard to creating offsetting long/short portfolios (this is where, using the example above, constituents may be duplicated in both the DAX and the MSCI Europe ex UK Index, meaning elements of the long and short legs net off providing no net exposure, but still tie up capital and incur fees); and leverage swap reset periods.

But get it all right and leveraged ETPs could give your portfolio a much-needed kick-start in what is otherwise a low-return environment.

Please read disclaimer.