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Leveraged and Inverse ETFs Contain Extra Costs for Buy-and-Hold Investors

Exchange traded funds are a popular way to invest to gain exposure to an index or an industry sector. If you’re bullish on a sector, they take the work out of selecting individual stocks within that sector. Instead, an ETF allows you to be exposed to many stocks and earn the mixed return of its holdings (less mgmt. fee). This is a valid, and for some, prudent way to invest. It would seem to stand to reason then, with the market’s recent performance, that if you think the equitiies may be weak for a long period that you could invest in an inverse ETF, or even a 2x or 3x inverse. However, it isn’t that easy. There is great danger in these so-called “geared ETFs.” Traders should fully understand this danger so they don’t get caught.

Leveraged or geared ETFs are not invested the same way an index mimicking 1x ETF is. This difference limits their usefulness; they can serve effectively as a hedging tool short term but are likely to fail as a long-term investment play.

Background

The underlying financial tools in a leveraged or inverse ETF are reworked each day to deliver a set positive or negative multiple of the performance of an index. Individually their objective may be to attain the goal over a given time period, such as one day or one month. The most common of the currently listed geared ETFs, leverage factors are 1.5x, 2x, and 3x and inverse factors are -0.5x, -1x, -2x and -3x.

The vast majority of geared ETFs reset their exposure factors each day. This means that the stated leverage or inverse objective they aim for is within a single trading day, generally measured from the close of trading on one day to the close of trading on the next day.

The objective of a geared ETF with a daily reset is to provide that degree of leveraged or inverse exposure for that single period – not over longer (or even shorter) periods. (Similarly, a geared ETP with a monthly objective is designed to provide that leveraged or inverse exposure for a specified monthly period.)

Holding a geared ETF for a period that is shorter or longer than its objective can lead to performance that may deviate significantly from the daily objective. In other words, if you are invested in a 2x inverse S&P 500 ETF, and the benchmark falls 1% in 24 hours, the security should provide you with 2% in return. However if you hold the inverse leveraged ETF for two months and the S&P 500 average decline is 1%, you may have several percentage points eroded from your account assets. I’ll explain below. The investment product is not designed to provide twice the positive or inverse return of the index over longer periods.

Another example is an inverse ETF that seeks to deliver negative 1x the performance of the Nasdaq 100 Index. This ETF aims to deliver a return that is exactly the opposite of what the index returns (whether positive or negative) on a given day. If the Nasdaq 100 closes up 1.5 percent, the inverse ETF would aim to return a loss of 1.5 percent. If the index closes down 2 percent, the ETF should return a gain of 2 percent.

Why Don’t they Function Longer Term?

To achieve their expected returns, leveraged and inverse ETFs employ a range of investment strategies, including swaps, futures, and other derivatives in addition to possible long or short positions in securities.

Since geared ETFs are only designed to accomplish the stated leveraged or inverse objective on a daily basis, they don’t orchestrate their underlying financial instruments to accomplish anything different than that objective. It simply isn’t their goal. In fact, returns often differ significantly from the performance (or inverse of the performance) of their pegged benchmark over an extension beyond the stated period of time. This makes these products risky if they are held medium or long term, especially in volatile markets. While these ETFs can be held for periods that don’t align with their stated objective, generally, the position should be monitored closely and used by investors who understand what the products are designed for and how they incur costs to the longer-term holder – that performance is warped over extended periods.

The fund manager incurs a large daily cost by resetting the underlying instruments, far greater than a straight 1x ETF. Also, most of the underlying instruments incur futures decay as they move closer to their expiration date. Over one day this decay is accounted for in the daily mix, over a longer time period it is felt by the investor.

Things to Consider

Before committing money to any of these ETFs, clearly understand the specific leveraged or inverse ETF before investing in it. Be sure about your own purpose in committing money. Could the ETF accomplish or undermine your goal? Read the prospectus, and understand the objectives, risks, and costs.

When Might You Use a Geared ETF

Most of these ETFs are created to be used to hedge a portfolio or trading position overnight. Trading desks, institutional managers, and savvy retail investors with overnight positions may wish to protect against a large change in portfolio value while they are sleeping or through weekend.

For example: If a trading desk is long $600,000 in stocks that would be expected to roughly track the Russell 2000, before the close they may protect the position from any big moves overnight by committing $200,000 to a 3x ETF of the index.

Take-Away

Leveraged and inverse ETFs are designed as very short-term hedging and risk management tools. Investors that are considering a strategy to implement either short ETFs or leveraged should read the prospectus and understand the particular ETF thoroughly. Review the performance over a year versus the expected index.

Paul Hoffman

Managing Editor, Channelchek

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