Look Both Ways: What Are Leveraged and Inverse ETFs?

When ETFs lose (or make) more than the market they’re tracking, you might be holding an inverse or leveraged ETF.

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7 min read
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Key Takeaways

  • 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! 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. 

Let’s face it: The stock market sometimes sounds sour notes for investors or gets just plain noisy. How can you not only turn the cacophony into something resembling beautiful music but also pump up the volume on potential returns? That’s what leveraged ETFs and inverse ETFs look to do.  

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 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 of these ETFs. 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 and how could you use them?

A leveraged ETF is an exchange-traded fund that pools investor capital, then uses derivatives 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. 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 S&P 500 drops 1% in a day, a 2x S&P 500 leveraged ETF should post a -2% return.

What are some 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 from. 

Investors should be very careful with leveraged ETFs. It’s a common misconception that over the long term, as the S&P 500 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.  

Since leveraged ETFs are designed to return a specific multiple of daily returns, they reset their leverage exposure every day. Markets are volatile and this can complicate matters. Because the leverage exposure is reset on a daily basis, 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. The compounding effect of this reset tends to make it difficult to measure the actual performance of a leveraged ETF.

With leveraged ETFs, investors can get stuck in a spiral of losses and might never recover their losses. Additionally, fees for leveraged ETFs can be high and erode returns.

Leveraged ETFs may serve other nuances. For example, an investor could use this product to access the broader market and attempt to replicate the day-to-day returns of a benchmark index while investing half of the proceeds in stocks and holding the other half in cash. Investors who may have particular liquidity needs, but still want to “fully” invest, might apply a leveraged ETF strategy in hopes of receiving daily returns that are similar to the S&P 500.

How are inverse ETFs different from leveraged 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 S&P 500 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, so 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 S&P 500 was up 1% in a day, the inverse ETF would invest to 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 the 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, as 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 late 2019, there were 2,353 ETFs listed in the United States with assets totaling over $4.4 trillion and an average value of nearly $79 billion traded each day, according to NYSE.

There are about 162 leveraged ETFs traded in the United States covering assets totaling $40.7 billion, according to ETF.com, a subsidiary of exchange operator Cboe Global Markets.

How can inverse ETFs be used?

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 selloff. Rather than selling actual stocks, the investor could purchase an inverse S&P 500 ETF—effectively, a position that could profit if the market declines.

Inverse ETFs allow investors to short the market without taking on the liability of shorting a stock. 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.

What inverse ETF risks must investors consider?

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 might expect.

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 understand 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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Key Takeaways

  • 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

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