Love them or hate them, leveraged and inverse exchange traded funds (ETFs) have become a large part of the ETF world. Whether or not you actually plan to use them for your clients, their benefits, cautions and inner workings are worth understanding.

What They Are and How They’re Used

This fund type aims to magnify the daily moves of the market through double- or triple-leverage in either the long- or short-direction.

For example, in a double-leveraged inverse ETF, if the underlying index loses 1% on any given day, the ETF would gain 2% for that day. It should be noted that these types of funds have a daily target. Daily targets help limit risk by preventing a case of too much leverage, mitigate risk of losing more than what’s in the fund and provide a constant level of leverage for investors coming in after if the first day isn’t possible.

Because they’re designed for daily targets, it makes them generally unsuitable for long-term buying-and-holding, especially in volatile markets. If you’ve made the decision that they’re right for your clients, you need to be prepared to watch them closely and be ready to act accordingly.

Leveraged and inverse ETFs have several appealing uses, the main ones being:

  • These funds can be used as a hedge if you believe the market is due for a short-term correction (or upswing) and you want to capitalize on it.
  • If you are holding a position, but don’t necessarily want to sell it, then a leveraged or inverse ETF can be used to hedge against any potential loss.

Compounding Explained

As stated above, all leveraged and inverse ETFs reset daily and generally reflect their respective indexes. For stable markets, the system works very well. Over time, though, you will see a leveraged fund drift from its benchmark due to the effects of compounding, even in market stability.

This compounding isn’t necessarily a bad thing, either – it can work both ways.

The negative impact is really evident in markets such as those in 2008-2009, when record volatility hit the funds. With that volatility, leveraged funds started veer off from their benchmarks by wide margins. This may be a side effect of compounding in an extremely volatile market, as opposed to just a side effect of volatility.

Still, it still holds that over longer periods, there is a higher probability of approximating the one-day target, according to a study conducted by Profunds. The shorter the period and the lower volatility of the index, the more likely approximating the target becomes and the impact of compounding over the long-term is essentially neutral.