As the U.S. prepares for potential risks that could topple the markets’ push toward new highs, investors may look toward leveraged and inverse exchange traded funds to hedge against potential volatility.

On the recent webcast, Smarter Beta: Tricks of the Trade for Leveraged ETFs, Sylvia Jablonski, Managing Director and Head of Capital Markets & Institutional Strategy Team at Direxion, pointed to hot button topics that have shaken traditional asset categories, such as the gold swings this year, rising uncertainty surrounding the upcoming presidential election and positioning in a post-Brexit environment.

Consequently, more traders are looking at alternative investment options like leveraged and inverse ETFs to hedge against the swings. However, potential investors should note that these geared ETFs are not like traditional beta-index funds.

Leveraged and inverse ETFs utilize derivatives to achieve their exponential or inverse returns. The derivatives include instruments like swap agreements, futures and forward contracts, and put and call options.

Potential traders should keep in mind that these leveraged ETFs are designed to produce double or triple the performance of the underlying market on a daily basis. Consequently, when investors look at the long-term performance of a typical leveraged ETF, people may notice that the funds do not perfectly reflect their intended strategies.

A strong bull market without long interruptions and relatively low volatility help maintain positive gains in the leveraged ETF. Since the ETFs rebalance on a daily basis, the compounding effect benefits leveraged ETFs in an upward-trending market. In an upward-trending market, compounding can generate longer-term returns that are greater than the sum of the individual daily returns. Similarly, in a downward-trending market, compounding can generate longer-term returns that are less negative than the sum of the individual daily returns.

On the other hand, in times of increased volatility, leveraged ETF returns can fall behind their intended 2x or 3x strategies. Over the long-term or during periods of intense volatility, compounding can generate long-term returns that are less than the sum of the individual daily returns.

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