Two variations of exchange-traded funds (ETFs) are leveraged ETFs and their counterpart, inverse ETFs.
Like most ETFs, leveraged ETFs are funds that are listed and traded like stocks and are designed to match the performance of a particular index. But, there are two distinct differences:
1. Leveraged ETFs magnify exposure to an index. While a regular ETF will attempt to match the benchmark index's performance 1:1, a leveraged ETF will usually match it 2:1 or 3:1. That means for each $1 you have invested, you have $2 or $3 of exposure to the index, magnifying your potential risk and volatility by 200% or 300%. This additional exposure comes from derivative investments. Leveraged ETFs will often have a significant percentage of their holdings in futures and swaps, and the funds are compounded daily.
2. Leveraged ETFs have daily investment objectives. A leveraged ETF might meet its goal of performing at 200% of the benchmark on each individual trading day, but over time, the fund's performance in relation to the benchmark will likely be significantly different due to the effects ofcompounding. Investors should monitor the performance of their leveraged ETF investments daily and relate it to their investment strategy and risk tolerance. These investments may, in fact, deliver an opposite return than the benchmark over a period of more than one day.
Inverse ETFs have the same daily goals and magnified exposure as leveraged ETFs, but they aim to perform opposite their benchmark index. For example, if an index goes up 1%, a corresponding 2:1 leveraged ETF would go up 2%, and a 2:1 inverse ETF would go down 2%.
Understanding why leveraged ETFs do not maintain their 2:1 or 3:1 performance relative to the benchmark index over time is key to understanding the risk involved in these investments. Take, for example, a $100 investment in a traditional ETF, an equal investment in a 2:1 leveraged ETF and another $100 in the corresponding 2:1 leveraged inverse ETF:
Day | Index | Traditional Index ETF | 2:1 LeveragedIndex ETF | 2:1 Leveraged Inverse Index ETF |
1 | 0 | $100.00 | $100.00 | $100.00 |
2 | 5.35% | $105.35 | $110.70 | $89.30 |
3 | -6.00% | $99.03 | $97.42 | $100.02 |
4 | -10.00% | $89.13 | $77.93 | $120.02 |
5 | 10.00% | $98.04 | $93.52 | $96.02 |
6 | 6.20% | $104.12 | $105.12 | $84.11 |
7 | -3.95% | $100.00 | $96.81 | $90.75 |
| | $0.00 | -$3.19 | -$9.25 |
In the hypothetical example above, the traditional ETF that follows the benchmark index ended the seven trading days back at $100.00, breaking even. The leveraged ETF lost more than 3% of the original investment, while the inverse ETF lost nearly 10% of the original $100.
Because of the magnified exposure to the benchmark index, the volatility is magnified in the leveraged funds, and we see stronger up and down swings. And because the percentage movement up or down is affected by compounding, meaning it is based off of the final price from the previous day, it is harder for the leveraged funds to recoup their losses.
As a relatively new investment product, leveraged ETFs provide the investment community a learning opportunity to determine whether these investment vehicles are best suited for short-term, mid-term or long-term investing. Analysts point out that, as in our example above, often the daily movements can be more profitable than multi-day returns, but this type of performance is not guaranteed. Investors should evaluate their personal investment strategy and risk tolerance before deciding whether leveraged or inverse ETFs are the right choice for them.
Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange-Traded Fund (ETF) carefully before investing. Leveraged and Inverse ETFs may not be suitable for all investors and may increase exposure to volatility through the use of leverage, short sales of securities, derivatives and other complex investment strategies. These funds' performance will likely be significantly different than their benchmark over periods of more than one day, and their performance over time may in fact trend opposite of their benchmark. Investors should monitor these holdings, consistent with their strategies, as frequently as daily. A prospectus contains this and other information about the ETF and should be obtained from the issuer. The prospectus should be read carefully before investing.
