Leveraged and Inverse ETFs: What You Should Know

January 19th at 1:50pm by Tom Lydon

Inverse or bearish exchange traded funds have seen huge growth within the investment industry. These funds are intended to move opposite the underlying index or sector they track. Some return two or three times the negative performance of the index or sector they are attached to.

“While it may be tempting to use a leveraged or inverse ETF to capitalize on an investing idea or as a hedge, investors would probably be better served by using unleveraged products or adjusting their asset allocation,” Michael Rawson wrote in an analyst report for Morningstar.

Leveraged ETFs can be a useful tool for traders looking for more bang for their buck. They can put on positions with less capital, for example. [Special Report: Leveraged and Inverse ETFs]

The leveraged funds tend to diverge from long term expectations, which makes them unsuitable as buy-and-hold tools generally. The goal of most leveraged ETFs is to return twice the underlying index on a daily basis, leading to less emphasis on the products long term performance accuracy, reports Investopedia.

Traders that have a short-term trading strategy will benefit the most from these types of funds. By using the funds to capitalize on daily movements in the market or a specific sector, the ultra ETFs give leverage to a portfolio. Most traders that use these funds are knowledgeable and get in and out within one day.

One example of a leveraged bullish ETF is the ProShares Ultra S&P 500 (NYSEArca: SSO), which was designed to give double the performance of the Standard & Poor 500 index on a daily basis. In theory, if the S&P 500 gained 1% during a trading day, SSO would be up 2%, reports Mark Cison for Investopedia. [How to Use Leveraged and Inverse ETFs]

“The mathematics of compound interest make volatility a hidden cost to these funds beyond the already high expense ratios. The SEC is examining the need for additional investor protections for leveraged and inverse ETFs and had put a temporary halt to the issuance of new derivatives based ETFs. In addition, FINRA has cautioned its broker members on the sale of leveraged ETFs,” explained Rawson on Morningstar.

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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