Exchange-traded funds, or ETFs, are listed on exchanges and traded like shares of stock
Leveraged ETFs and inverse ETFs use derivatives with the aim of amplifying returns
Understand the unique risks associated with leveraged and inverse ETFs
Leveraged and inverse ETFs entail unique risks, including but not limited to: use of leverage; aggressive and complex investment techniques; and use of derivatives. Leveraged ETFs seek to deliver multiples of the performance of a benchmark. Inverse ETFs seek to deliver the opposite of the performance of a benchmark. Both seek results over periods as short as a single day. Results of both strategies can be affected substantially by compounding. Returns over longer periods will likely differ in amount and even direction from the target return for the same period. These products require active monitoring and management, as frequently as daily. They are not suitable for all investors.
Wow! That’s quite the disclaimer. Lots of unique risks. High maintenance. Possibly more expensive than other exchange-traded funds (ETFs). Not exactly an enticing come-on, right? Well, it all depends on your objectives and appetite for risks, but these products are not suitable for most investors.
You’re probably familiar with ETFs. They’re listed on an exchange and traded like stock, allowing investors to buy or sell shares aimed at following the collective performance of an entire index or some other stock or bond portfolio. Other ETFs track commodities, such as crude oil and gold. Leveraged and inverse ETFs are different in that they’re not designed to be held for a longer period of time.
To better understand the characteristics of leveraged and inverse ETFs, let’s look at a few basic questions about each. Remember to pay special attention to the disclaimer up top. Relative to other ETFs, leveraged and inverse ETFs do carry special risks. Here’s what you need to know about them.
What are leveraged ETFs?
A leveraged ETF is an exchange-traded fund that pools investor capital, then uses derivatives, such as swaps, options, and futures, in an attempt to amplify daily returns on a benchmark index or other reference.
By applying leverage, these ETFs may, for example, try to double (2x) or triple (3x) the daily performance of the S&P 500® index (SPX). A leveraged ETF with a 2:1 ratio matches each dollar of investor capital with an additional dollar of debt. If the underlying index returns 1% in one day, the ETF will in theory return 2%. If the SPX drops 1% in a day, a 2x SPX leveraged ETF should post a –2% return.
Unique risks of leveraged ETFs
Because leveraged ETFs target a multiple of a percentage of daily performance, if it moves against the intended direction, you could experience significant losses. For example, a 5% drop in the S&P 500 could translate to a 10%, or more, tumble for a 2x leveraged ETF. That’s quite a big hole to dig yourself out of.
Investors should be very careful with leveraged ETFs. It’s a common misconception that over the long term, as the SPX or any other reference index rallies, investors in leveraged ETFs will receive multiples of that performance. This is far from the case. If the market trends in one direction every day, then the performance of leveraged ETFs can be more in line with their specific multiple. But the reality is markets don’t trend in the same direction every day.
Leveraged ETFs are designed to return a specific multiple of daily returns, so they reset their leverage exposure every day. Because of the reset, the performance results may not be as clear cut, especially if you’re looking at them from the perspective of anything longer than a day. For example, if the index goes up in value, the ETF will have to increase its exposure to the index for the next day to maintain its multiple. Resetting can result in a difference in the returns of the ETF compared to the underlying index.
The resetting difference could compound losses or even cause losses despite the underlying index moving in the desired direction, especially in volatile markets. Additionally, fees for leveraged ETFs can be high and may further erode returns.
What are inverse ETFs?
Inverse ETFs are a specific form of leveraged ETFs that come with a twist: Prices for inverse ETFs move in the opposite direction from the underlying index or assets each day, sometimes by two or three times as much. So, if the SPX rises or falls by some amount in one day, the price of a 2x SPX-linked inverse ETF would look to return twice the inverse of the index just for that day.
This “playing opposites” angle can make inverse ETFs a handy hedging tool and provides an alternative to traditional short-selling strategies. But inverse ETFs also carry special risks. For example, the ETF’s inverse and/or magnifying effects may have the desired effect last just one day, so the ETFs should be considered a very short-term hedge. This is one reason why it’s critical that investors understand how these instruments work.
An inverse ETF aims to post the opposite return of a certain reference benchmark every day. For instance, if the SPX was up 1% in a day, the inverse ETF would deliver –1%.
Inverse ETFs do this by pooling assets and, typically, using those assets to access the derivatives market to establish short positions. The intent of an inverse ETF is for an investor to benefit when its reference benchmark declines in value.
ETF Hit Parade: A Quick Rundown
ETFs are still relative newcomers to the investing world; they were introduced in the early 1990s. The first U.S.-listed ETF was launched in January 1993. Soon after, the ETF market took off.
Many investors use ETFs in their diversification strategies or for certain strategies.
As of early 2023, there were more than 3,000 ETFs listed in the United States with assets totaling more than $6.8 trillion and an average value of nearly $149 billion traded each day, according to NYSE.
There are about 173 leveraged ETFs traded in the United States covering assets totaling $24.33 billion, according to ETF.com, a subsidiary of exchange operator Cboe® Global Markets.
How to use inverse ETFs
Suppose an investor has a portfolio that’s heavily weighted with stocks to hold for the long term but is concerned about the possibility of a short-term sell-off. Rather than selling actual stocks, the investor could purchase an inverse SPX ETF—effectively, a position that could profit if the market declines. However, the opposite occurs if the market continues higher. The investor could experience a severe loss due to the extreme level of risk compared to smaller and transparent costs of traditional hedge approaches.
Inverse ETFs allow investors to short the market. When an investor shorts a stock outright, the loss potential is unlimited. In contrast, with an inverse ETF, the investor doesn’t have to borrow the stock on margin; it’s the initial investment in the ETF that’s at risk. And inverse ETFs don’t require investors to borrow on margin. Remember, this approach carries special risks and is meant to be used as a short-term hedge.
Unique risks of inverse ETFs
Much like trading stocks with margin, inverse ETFs can cut both ways. Both gains and losses can get magnified quickly with inverse ETFs, and even if the underlying index goes the way you want it to, that doesn’t mean you’ll see the returns you expect.
Another way price volatility can lead to losses is if major movements in the underlying index are so extreme, that the losses result in the leveraged ETF falling below a fund’s preset minimum value. If this happens, the leveraged ETF may be forced to close. Fund closures can lead to major losses for investors.
In general, investors considering leveraged or inverse ETFs need to understand why they’re choosing these instruments and be prepared not only for the potential for large gains but also for even larger losses. If you wish to use these ETF products, be sure to read the prospectus and have a complete understanding of their risks, how they’re structured, and the effects of compounding returns over periods longer than a day.
Carefully consider the investment objectives, risks, charges, and expenses before investing in any ETF. A prospectus contains this and other important information about an investment company. Read carefully before investing.
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