What is an ETF? -- Part 16: Inverse and Leverage Funds | ETF Trends

Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 15: World Currencies]

Even with the controversy and greater scrutiny over inverse and leveraged ETFs, the investments are still a great hedging tool. Nevertheless, potential investors should fully understand how they work to efficiently utilize the funds in a tactical portfolio.

Leveraged ETFs try to magnify the daily movements of an underlying asset or index through a double- or triple-multiplier by using derivatives or futures contracts designed to earn a multiple of the return for a given Index. Inverse ETFs also use derivatives in an attempt to achieve a negative, or inverse, multiplier to the direction of the underlying asset or index.

For instance, if the underlying index goes up, a long 2x-leveraged fund will jump twice that amount for that specific trading day. For a short fund, if the index goes up, the fund will mirror the negative performance of the index for that day. The general idea also applies to other inverse and multiples-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. It should be noted that inverse and leveraged funds will specify whether or not they rebalance to provide a daily or monthly target.