Leveraged and inverse exchange traded funds (ETFs) have become a large part of the ETF universe; and, it is worth understanding the inner workings of these investment styles in order to maximize their full potential while minimizing the potential downside risk.
The Inverse/Leverage Theme
Leveraged and inverse ETFs attempt to magnify the daily movements of an underlying asset or index through a double- or triple-multiplier in either the long- or short-direction by using derivatives and hedging strategies designed to earn a multiple of the return for a given index.
For instance, if the underlying index goes up, a long 2x-leveraged fund will jump twice that amount for that specific trading day. In a short-leveraged fund, if the index goes up, the fund will drop two times the performance of the index. The same general idea also applies to other multiple-leveraged ETFs.
Most leveraged funds are designed to provide a daily target so they may limit risk from too much leverage and reduce the risk of losing more than what is in the ETF.
Since leveraged funds try to track the daily movements of an underlying index, these funds are not necessarily suitable for the long-term buy-and-hold investor, especially over periods of high volatility. Consequently, if an investor does hold a leveraged ETF over a mid- to long-term period, the investor will notice the funds will not perfectly reflect two times or three times the performance of the underlying index in either the long or short direction; this is do to compounding. Fund sponsors have made it clear in their prospectus notes that leveraged ETFs try to pursue daily leveraged investment goals, and the returns of a fund for a period longer than a full trading day will not translate to a 200% or 300% return of an index for extended periods since the aggregate return of an ETF is based on a series of daily leveraged returns for each trading session as a result of “daily rebalancing”.
ProShares conducted a study on leverage and found that while the effects of compounding may diminish the performance of a fund over time, compounding may also work in the investor’s favor. For instance, on a 2x fund, two day consecutive gains of 10% could translate to a total of 21% or two consecutive days of 20% losses may turn into an overall loss of 36% due to compounding. Since the effects of compounding may be positive or negative, the study revealed that the impact of compounding over the long-term is essentially neutral, and over an even longer-term period, an investor may get close to the 2x index target if volatility stays subdued. However, most leveraged funds have yet to actually show that they are capable of maintaining long-term leverage performances beyond a fund’s specified target daily performance. [Special Report: Leveraged and Inverse ETFs.]
Highlighting the Potential Benefits
While leveraged ETFs are mostly viewed as highly speculative and rather risky, these ETFs may actually help lower a portfolio’s overall risk. Leveraged ETFs may be perceived as investment tools that provide exposure to an area at half the price.
ETFs that provide leverage or inverse strategies may be appealing for avid day traders. These funds tend to be very liquid and can be used as a hedge for any short-term corrections or upswings. Furthermore, these types of ETFs may be used to capitalize on positive current events that could provide a nice boost to the markets. Leveraged and inverse products also provide the opportunity for daily ETF traders to jump in and make some money on quick market actions or capitalize on pessimistic market news.
Leveraged ETFs provide exposure to areas that have little or no substitutes, like futures markets. Without inverse/leveraged funds, investors would have to borrow from a broker to short with credit and then allocate money into reserve capital. Additionally, brokers will not always be able short trade the shares an investor wants and there will be limits on the types of options available, which would restrict an investors ability to execute bearish options strategies.
After a number of investors who did not fully understand the ramifications of investing in leveraged and inverse ETFs got burned, the ETF style started attracting the ire of media and government regulators.
“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,” according to a joint statement by the Financial Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). [The Advisor’s Guide to Leveraged and Inverse ETFs.]
More recently, state regulators are suing RBC Capital Markets LLC due to the dishonest practices in the sale of leveraged and inverse exchange traded funds. The regulators contend that both the investors and the agents soliciting investments did not fully understand the inner workings of these funds. After the initial probes into leveraged and inverse ETFs back in July 2009, money managers have begun to place training requirements on agents who advised on these types of products.
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.
Available Inverse/Leverage ETF and ETN Options
Inverse and leveraged funds offer exposure to bonds, commodities, currencies, equities and real estate assets. Currently, there are around 316 leveraged ETF options and 241 inverse ETFs.
Leveraged and inverse fund products utilize financial engineering techniques, such as swaps, derivatives, futures contracts and rebalancing, to achieve their desired investment goals.
Since most leveraged and inverse ETFs gain exposure to their underlying indices through different investment instruments, it’s important to know the tax implications; investors are urged to discuss this with their tax expert.
Direxion and ProShares are prominent and prolific fund sponsors of leveraged and inverse ETF products. Their products cover most sectors and broad indices in the equities markets, both domestic and international, along with 2x/3x long/short exposure to the benchmark indices.
ProShares, Market Vectors and PowerShares provide leveraged/inverse funds for the Japanese yen, European euro and U.S. dollar.
PowerShares also has a line of leveraged or unleveraged long/short commodity ETFs.
These fund providers also offer leverage/inverse fund products tailored for various U.S. Treasuries and international Treasury bonds.
Barclays iPath provides a large line of exchange traded note (ETN) debt instruments designed with leveraged exposure in either bullish or bearish directions.
FactorSares, a recent entrant to the leveraged ETF game, has launched a line of leveraged bets that track the spread between two major indices.
Our ETF Analyzer page helps visitors screen for the available leveraged or inverse ETF options currently listed. Potential investors may want to head to our ETF Resume page to take a look up funds and browse an ETF’s prospectus sheet.
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.