Today’s ETF Chart of the Day includes a look at leveraged and inverse exchange traded funds that let traders position for strength or weakness in the euro relative to the U.S. dollar.
Although investors have been warned repeatedly about the increased risks of leveraged ETFs, it’s always worthwhile to revisit this important issue, especially in such a volatile market.
Leveraged ETFs are “a day trader’s dream, and they’ve been increasing in popularity,” Fortune reports. “But beware: Used improperly, these high-octane investments can wreak destruction on your portfolio — even if the market moves the way you anticipated.”
Inflows to leveraged ETFs have jumped recently, and the category represents about $45 billion in investor assets. “As the market tumbled in August, investors plowed about $3 billion into leveraged ETFs, the second-highest money inflow of all ETF categories,” Fortune reported.
Leveraged funds are more complex and need to be monitored very closely. If held for more than one day, investors may get a different result than they expect, particularly in volatile markets, due to the effect of compounding and the fact that the ETFs reset the leverage each day. [How Volatility Impacts Leveraged ETFs]
Many traders like the idea that leveraged funds may generate two or three times the return of an underlying benchmark, writes Michael Thomsett for Minyanville. However, that same leverage also applies to the downside. [What Are ETFs?]
Leveraged ETFs try to reflect 200% or 300% of the daily performance of an underlying index. For instance, if the underlying benchmark rises by 1%, a 2X leveraged ETF will rise by 2% and a 3X leveraged ETF will rise by 3%. On the flip side, if a benchmark falls, the leveraged ETFs will also reflect a 2X or 3X drop.
Furthermore, a leveraged inverse ETF — a fund that tries to reflect the opposite performance of a benchmark — will also have the same risks. [Short ETFs – These Funds Profit When Stocks Fall]
Critics of leveraged ETFs have been quick to accuse the investment vehicle of exacerbating volatility in the markets, especially at the end of the trading day. However, leveraged products are not to blame for higher volatility. [Nasdaq Exec Says ETFs Not to Blame for Market Volatility]