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]
According to a recent Credit Suisse report, Ana Avramovic, vice president of Credit Suisse, stated that the criticism comes from a lack of understanding of the investment product, reports Chris Flood for the Financial Times.
Due to daily rebalancing requirements, leveraged ETFs will always buy or sell underlying components in the same direction the markets are moving. There is an equal chance that the market could reverse direction in the final hours of trading, Credit Suisse analysts found.
“If leveraged ETF rebalancing were truly driving the market, the [price]trend should always continue into the close,” Avramovic said in the FT story.
Additionally, ETF trading volumes are higher at the opening of a trading day, whereas overall volume in U.S. equities wanes toward the end of the day.
“What may be behind the shift is an increased use of VWAP strategies,” Avramovic added. VWAP, or volume weighted average price, is a trading benchmark used by pension plans. If a trade is lower than the VWAP, it is considered an optimal trade.
“Since the end of the day sees higher volume, it plays a larger role in determining the VWAP. It is therefore easier to achieve VWAP by trading at those times,” Avramovic said. “Of course, that process then creates positive feedback, generating more and more volume near the close.”
For more information on leveraged funds, visit our leveraged ETFs category.
Max Chen contributed to this article.