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.

Government Scrutiny

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.]

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