When investing, it can be very rewarding or costly if you are willing to take certain risks. Inverse and leveraged ETFs are risky because they increase your profits and losses many times over based on market changes.
These types of ETFs are short-term oriented and have the objective of obtaining daily performance results. They could be better for long-term investors who invest their money and let it grow gradually through compounding.
The majority of these high-risk trading instruments are ETNs rather than ETFs. ETNs are debt instruments and therefore have the inherent risk of credit risk, or in other words, the issuer may fail to meet the obligations.
In this post, we will discuss the specifics of the inverse and leveraged ETFs and how they can achieve a multiple of the index return on a daily basis.
Leveraged and Inverse ETFs: What Are They?
First of all, understanding the basic mechanics of traditional ETFs is useful in order to comprehend the mechanics of leveraged and inverse ETFs. A conventional passive ETF aims at replicating the price return of an index that may be the S&P 500 index. It tracks the index by holding the same stocks and experiencing similar fluctuation in price as the index. For instance, if the Nasdaq 100 rises by 1%, an ETF that follows that index like the Invesco QQQ (QQQ) also increases by 1%.
Leveraged ETF
In the finance world “leverage” is a tool that is used to increase an investor’s gains and losses. Thus, a leveraged ETF implies that the fund seeks to offer a more boosted return on the index’s daily movements.
Therefore, if for instance, the market index increases by 1% in a particular day, the 2x leveraged ETF should increase by 2% in that particular day. However, if the index declines by 1% that day, the 2x Leveraged ETF would drop by 2%.
Inverse ETF
The word “inverse” means the “opposite” of the given word or statement. Therefore, by inverse ETF it means that the fund seeks to give the investors a return or performance that is inversely related to the daily performance of the index.
Therefore if the index decreases by 1% on a particular day, it means that a 1x inverse ETF should increase by 1% on the same day. On the other hand, if the index rises by 1%, then the 1x Inverse ETF would fall by 1% on the same day.
How Leveraged and Inverse ETFs Work
These ETFs are not ideal for long-term holding but are suitable for short-term speculation and trading. While these ETFs have the mentioned objectives, there is usually a gap between the targeted return and the realised returns in the long run.
Leveraged ETFs try to provide a multiple of the daily performance of an index whether it is two, three or ten times or the inverse. In dollar terms, it means that the objective is to get $2, $3 or $10 for each dollar invested versus the daily performance of indices.
The most inverse and leveraged ETFs are rebased daily for their settlement price and the next trading day, the ETF aims at delivering the targeted leveraged as well as inverse performance.
If a fund is held for longer than a day, the return is a combination of daily leveraged returns depending on the number of days the investor holds the fund.
The Securities and Exchange Commission (SEC) provides this example to illustrate how a two-times leveraged fund performs on a down day followed by an up day:
The value of a stock index on day 1 can be at 1,000. Similarly, a leveraged ETF that has as its aim to deliver double that return begins at $1,000.
If the index is down 100 points by the end of the first day, it has declined by 10 per cent to 900. The leveraged ETF declined in value by 20% and is now worth $800.
On day 2, the index increases by 10% to be at 990. The value of the ETF increases to $960 as it increases by 20% of its initial value of $800.
Who Should (or Shouldn’t) Use Leveraged or Inverse ETFs?
Leveraged or inverse ETFs are best suited for active traders who are willing to take more risks in the market, and they should be avoided by conservative long-term investors.
Leveraged and inverse products are trading products and come with high risks of loss for investors.
- Recognises and agrees with the prospect of high levels of loss.
- Is aware of shorting an investment and the various implications that are associated with the process.
- Acknowledges that the daily reset may have a negative effect on performance over a greater number of days.
- Can handle a position—that is, the quantity of the stock or any other investment asset—on a daily basis.
They are not for you if you cannot afford to lose a lot of money at one time or if you have no idea how these funds work.
How They Work For You
Leveraged ETF and Inverse ETF typically employ a leveraged financial derivative and debt to create the daily amplified return or the daily negative return of the index.
Since the goal of such investment is usually to track daily returns that are usually targeted by the index most of the Leveraged and Inverse ETFs are designed to rebalance their investment in a daily basis to maintain the target leverage ratio.
This means that Leveraged and Inverse ETFs are suitable for short-term investment strategies rather than long-term positions.
