Leveraged and inverse exchange traded funds (ETFs) can be a boon or a bust, depending on an investor’s knowledge and skill in using the unique investment tool. Most people trade with this type of ETF in a short bursts, but there is a way to use this tool in a long-term strategy.

In a study conducted on leveraged and inverse fund investments in the S&P 500, it is shown that that there is a high probability of approximating one-day targets for periods longer than a trading, write Joanne Hill and George Foster for IndexUniverse.

Leveraged and inverse ETFs were made to reflect a multiple, be it positive or negative, of a benchmark’s returns on a daily basis. For periods greater than a day, returns can be higher or lower than the one-day target multiple times the benchmark, which is the effect of compounding. This effect is heightened during a volatile market.

On average, the impact of compounding is practically neutral for most broad indexes. The effects of leveraged and inverse strategies are likely to equally benefit or hurt as a result of compounding for up to 30 days in the S&P 500.

Shorter periods with lower index volatility result in higher probability of meeting one-day targets, but rebalancing the size of one’s fund positions could be an effective mechanism for approximating daily leverage targets over time. This involves checking index returns against fund returns and setting a trigger percentage of deviation as a marker for rebalancing.

Nevertheless, an investor should be aware of two things:

  • Returns from the rebalancing strategy can be lower than those of an un-rebalanced strategy during trending markets or low market volatility
  • The use of rebalancing also may remove the negative as well as the possible positive effects of compounding

By using leveraged and inverse ETFs in a long-term portfolio strategy, an investor may pursue returns while managing risk of long equity and fixed-income positions. It should be noted that there is a high correlation between the length of holding and the probability of hitting a beta close to daily targets.

The rebalancing process, the study says, is straightforward:

  • Observe the gap between the return of the index and the return of the ETF
  • Rebalance the holdings when the gap goes past a pre-set trigger (or at fixed intervals)
  • The investor would lower the fund exposure if the return of the index is less than that of the fund; vice versa if the return of the index is more than that of the fund

For more stories on leveraged and inverse ETFs, visit our long-short ETF category page.

Max Chen 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.