Breaking down leveraged and inverse exchange-traded products
- Leveraged and inverse exchange-traded products (ETPs) are complex investments that may provide amplified gains, but also substantial losses.
- Generally, leveraged and inverse ETPs are not intended to be held longer than one day.
- They carry significant risks and generally have higher management fees and expenses than traditional ETPs.
- Leveraged and inverse ETP performance can also be drastically different than the stated performance objectives, if held longer than one day.
- Before investing in leveraged or inverse ETPs, you should fully understand how they work and read the prospectus.
What are leveraged and inverse exchange-traded products?
Leveraged and inverse exchange-traded products (ETPs) are considerably different than traditional exchange-traded products. They come with unique risks that investors should be aware of before incorporating them into their portfolios.
Leveraged ETPs are designed to amplify the daily movement of a benchmark. Inverse ETPs aim to replicate the daily movement in the opposite direction. An inverse ETP might strive to multiply a benchmark’s performance in the opposite direction, making it a leveraged inverse ETP.
When considering the differences between leveraged and inverse ETPs and traditional ETPs, it is important to highlight that leveraged and inverse funds use derivatives and other leveraged strategies to achieve their amplified benchmark-tracking strategies. What makes them even more complex? The underlying investments—typically futures, swaps, and other derivatives—have expiring lifecycles and must frequently be “rolled forward” or reset as the underlying products expire. This means that they have a much shorter and targeted time frame than the benchmarks they track.
Leveraged and inverse ETP examples
To illustrate, let's consider a conventional ETP, a 2x leveraged ETP, and a -2x inverse ETP that follow the same index. We won’t include underlying fees in these examples for simplicity, but keep in mind there are costs that come with these investments, which will detract from the ETP’s performance.
Typically, if the benchmark index rose 1% on a given day, then:
- A conventional ETP, which attempts to match the index performance, could rise 1% on that day.
- A 2x leveraged ETP, which aims to double the index performance, could rise 2% on that day.
- A -2x inverse ETP, which seeks a negative 2x return, could decline 2% on that day.
These are examples of what could happen in just one day. When held for longer than one day, the performance of leveraged ETPs can significantly decrease due to compounding, the fund's daily rebalancing, and other risk-related factors when it comes to derivatives trading like backwardation and contango.
For example if the benchmark index rose 1% over two days:
- The conventional ETP, which attempts to match the index performance, could rise 2% over two days.
- The 2x leveraged ETP, which aims to double the index performance, could rise 4% over two days.
- The -2x inverse ETP, which seeks a negative 2x return, could decline 4% over two days.
Investing in leveraged and inverse ETPs
Advanced or professional traders may use leveraged and inverse ETPs in day trading or as a hedging strategy over a single trading session.
These ETPs are complex and should be monitored daily, so they are typically not a good choice for novice investors or long-term investors with buy-and-hold strategies. While some investors mistakenly believe a leveraged or inverse ETP multiplies the long-term performance of an index (or the inverse of an index), leveraged and inverse ETPs generally only seek to multiply such performance over just one day. Significant losses can result if they are not managed properly or held for longer than one day. Over the long-term, leveraged and inverse ETPs typically do not perform the same as the multiple or inverse return of their stated benchmark.
Pros and cons to consider
One advantage of leveraged ETPs is that they allow an investor to get more exposure to market movements without investing more money or buying on margin.
Inverse ETPs also have advantages, such as giving investors a way to profit or hedge existing positions during market declines without employing shorting strategies, as the process for buying inverse ETPs is often easier and less costly than shorting.
However, both leveraged and inverse ETPs have several significant potential downsides to consider, including the risks described above relating to holding leveraged and inverse ETPs for longer than one day, as well as unique risks from added leverage, which can increase volatility and rebalancing. The longer an investor holds an inverse or leveraged ETP, the greater the chance of potential loss given their volatile nature. These ETPs may also suffer from lower liquidity. Additionally, fees, costs, and taxes tend to be higher because the funds require more frequent trading, which can cut into an investor’s profits.
Also, ETP investors buy and sell shares of the products on exchanges, as opposed to transacting with the product itself. As a result, ETP investors are exposed to the risk, among others, that the market price of an ETP’s shares will not be equivalent to the daily net asset value (NAV) of the ETP’s shares.
The bottom line
Investors who use these ETPs should fully understand how they work, including all the material risks, and why they are using them.
Read the fund's prospectus, including details on its objectives, investment strategies, costs, and risks, before you make an investment decision. Those who choose to invest in leveraged or inverse ETPs should use extreme caution.
To learn more about Leveraged and Inverse Exchange Traded Products, explore these resources from FINRA and the SEC.