Leveraged and inverse exchange traded funds have taken their fair share of abuse in the press lately, but the high-octane financial products fill a legitimate need for short-term traders, and they can also be used to hedge.
Leveraged products are always the largest percentage movers during the day, which emphasizes their volatility. The ETFs are doing what they’re designed to do.
The basics: These volatile funds can reset their leverage on a daily or monthly basis. They can magnify the market’s performance by 200% or 300%, in either direction – inverse or “bearish” exchange traded products profit when the tracking index declines. [Primer on Leveraged and Inverse ETFs]
Leveraged and inverse ETFs deliver their strategies by investing in derivatives, which introduces counterparty risk. [Call for More Disclosure, Transparency in ETFs]
ETFs that short U.S. large-cap stocks include ProShares UltraShort S&P 500 (NYSEArca: SDS), ProShares Short S&P 500 (NYSEArca: SH), ProShares UltraShort Dow 30 (NYSEArca: DXD), Direxion Large Cap Bear 3x Shares (NYSEArca: BGZ) and Rydex Inverse 2x S&P 500 ETF (NYSEArca: RSW).
ProShares UltraShort S&P 500 tries to provide twice the inverse, or opposite, return of the S&P 500 on a daily basis.
“Leveraged funds are expensive and extremely risky, so they are best left to speculative traders or hedgers who have the desire to monitor and trade their positions daily,” wrote Morningstar analyst Michael Rawson in a profile of the ETF. “The mathematics of compound interest make volatility a hidden cost to this fund.” [How Volatile Markets Impact Leveraged ETFs]
Leveraged and inverse ETFs are sharp tools, so investors need to be careful. As always, it’s important for investors to know exactly what their ETF holds and how the strategy works. [Know Your ETF’s Holdings]
Despite recent negative headlines, leveraged ETFs captured 15% of the industry’s inflows in the third quarter. [Bond, Leveraged ETFs See Big Inflows]
Some of the other largest exchange traded products that short U.S. stocks include Direxion Financial Bear 3X Shares (NYSEArca: FAZ), ProShares UltraShort QQQ (NYSEArca: QID) and Direxion Small Cap Bear 3X Shares (NYSEArca: TZA).