In any well-rounded discussion of leveraged and inverse exchange traded funds (ETFs), a word of caution is always tacked on: understand them before you buy. Here’s what you need to know.
The government discourages investors from shorting the market. It can result in big losses and increased volatility if you don’t know what you’re doing.
ETFs have simplified this venture greatly. Until leveraged and inverse funds came to market, investors who wanted to short had to open a margin account. That could get complicated and costly. [Understanding Leveraged ETFs.]
Before you dive in, however, here are a few things to think about:
- What are you trying to do? Are you trying to capitalize on a short-term move in the market, or are you looking to hedge a position that you don’t want to sell? If you’re just buying the fund without any real reason or goal in mind, it may not be right for you. And that’s okay.
- Are you prepared to lose? Millions of investors have used leveraged and inverse fund with success, but many others have used them and lost. Do you understand the potential for such a loss, and are you comfortable with that?
- Do you know how they work? If you think that they’re going to perfectly track their underlying indexes long-term, that isn’t always the case. Compounding in leveraged and inverse ETFs is a phenomenon that results in imperfect tracking, which is more amplified in volatile markets. On a daily basis, these funds work as they ought to. Further out, and there may be a risk of compounding – but not always.
- Do you have a strategy? Know not only when you’ll buy, but when you plan to sell. And then stick to your guns. [Are Specialty ETFs for You?]
If you don’t know the answers to these questions, then leveraged and inverse ETFs may not be the best ETFs for you. And that’s okay – even the ETF providers plainly state that such products are not intended for everyone.
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.