Shedding Light on Misconceptions
The biggest misconception of leveraged ETFs is that they provide 2x or 3x the annual return of the underlying index. It should be noted that all leveraged ETFs try to reflect the multiple of daily, weekly or monthly returns of the underlying index and become increasingly less likely to provide returns that match the multiples beyond each ETF’s respective time frame because of the effects of compounding.
Many view leveraged ETFs as speculative and risky. If used properly, leveraged ETFs may actually lower a portfolio’s overall risk. Leveraged ETFs do not just allow for leveraged exposure, but can also provide an opportunity to access single exposure at half the price.
Like most ETF asset classes, leveraged and inverse ETFs have opened up new worlds and created more convenience for ETF investors. Before leveraged ETFs, investors were limited to shorting stock, which comes with a few hassles:
- Investors had to borrow from a broker to short with credit, and then have a required amount of reserve capital before doing so.
- A broker isn’t always able to find shares of the stocks you’d like to short.
- Even if shares are available, you may end up paying substantial costs in order to borrow those shares.
- You’ll also find limits on the types of options you can use, which may restrict your ability to execute bearish options strategies. Long-short ETFs can be a good answer
Government Regulation
Since leveraged and inverse ETFs may have been put to use by people who didn’t fully understand them and thus got burned, they have attracted the attention of regulators.
Last year, both the Financial Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) issued a joint statement, stating:
“These products are complex and can be confusing. Investors should consider seeking the advice of an investment professional who understands these products, can explain whether or how they’ll fit with the individual investor’s objective and who is willing to monitor the specialized ETF’s performance for his or her customers.”
The real lesson here isn’t necessarily that leveraged and inverse ETFs are bad tools that investors should avoid. On the contrary, they’re useful in certain situations and for certain types of investors. But even the providers plainly state that they are not for everyone.
To understand them better, we offer a prospectus on the ETF Resume page for any leveraged or inverse ETF!