Due to the risk involved, leveraged and inverse ETFs are viewed by some as investment tools for only the bold. In a recent episode of Trillions, Sylvia Jablonski of Direxion helps dispel some of the myths about these funds, sharing how they work and what you need to know to use these investment tools.
Leveraged ETFs use derivatives and debt to magnify the returns of an underlying index whereas inverse ETFs profit from a decline in the value of an underlying benchmark. The funds are used for investors to express high conviction on short term tactical opportunities, according to Jablonski.
In an example, Jablonski explained how these funds can work in an investor’s favor.
“We have a bear fund called SOXS. Now if the underlying ETF that we track is down 5% in a day, you have $100, $300 of exposure, 5% move, 3 beta fund, so you earn 15% as that ETF or that index goes down 5% in a day. On day two, if you have another downward move of 5% you make 17.25.”
This is the positive side of it where the compounding and rebalance work in an investor’s favor, she explained.
“The market has been trending downward. You got the direction right; 5% in two days gives you 32.25 over a 2-day period because of the 3x and because of the rebalance.”
On the flip side, there can be underlying conditions that might not work out in an investor’s favor.
Jablonski explains, “On the other side of that where you don’t do quite as well is if semiconductors is down 5% on day one and up 5% on day two. In this case your actually down 2.25 because on day one we rebalanced the fund.”
Due to the amplified exposure, these investment tools are primarily used by tactical traders that are in it for the short term.
For those using leveraged and inverse ETFs, Jablonski suggests the following:
- Know the basis of how the product works
- Understand that low volatility, trending markets are the best environment
- Actively monitor your position
- Rebalance frequently
- Have a high risk tolerance
Listen to the full Trillions podcast here.