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.
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!