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ETFs With Their Pants Down: Leveraged and Inverse Foibles

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April 1, 2014

Inverse and leveraged ETFs have become some of the most actively traded products.

And why not? Priced low, they can move around a lot, and let you make interesting speculations. For example, one ETF that tracks the Russell 2000 moves 3x the amount of the index. Another, a leveraged inverse ETF that tracks the S&P 500, moves -2x that index. And because it goes up when the S&P 500 goes down, it could be a way to hold a bearish position in an account that prohibits short stock positions.

If you trade options, the premium of a short out-of-the-money put* on a leveraged ETF can be much higher than the premium of a comparably out-of-the-money put on its benchmark due to their potential for higher volatility, which can lead to a higher risk of assignment. These are a few reasons ETFs can be so appealing to investors and traders.

But leveraged, inverse ETFs can also trip you up if you don’t understand how they work—whether you’re trading the ETFs themselves or their options. And the goal here is to clarify those distinctions. Sure, you’ll find all this information in an ETF prospectus. And I’d encourage you to read one. But here you’ll enjoy a more direct explanation in plainer language.

Less Than Zero?

First of all, leveraged, inverse ETFs are based on a given benchmark, which could be an index or another ETF. How much the price of a leveraged and inverse ETF moves is derived from the price change of its benchmark. How much the leveraged or inverse ETF moves relative to the benchmark is where it gets tricky because of the way it’s designed.

In the financial world, stocks, bonds, indices, and ETFs can’t have prices less than zero. No matter what happens, they can’t have negative prices. So, imagine an inverse ETF whose price moves in the opposite direction point for point with its benchmark price—when the benchmark moves up 1 point, the inverse ETF moves down 1 point. But, what happens if the index moves up more points than the inverse ETF is worth? For example, if the benchmark is $50 and the inverse ETF is $50, the inverse ETF would have a negative value, if the benchmark moves up $51 points to $101. A negative value could happen with leveraged ETFs if they move point for point, too. But, that doesn’t work.

So those who created inverse and leveraged ETFs solved the problem by basing the percentage change in the inverse and leveraged ETFs on the daily percentage change the benchmark. The benchmark moves up 1% in one day, and the inverse ETF moves down 1% on that day. But, what happens if the benchmark keeps going up in price, day after day? The inverse ETF keeps moving down in price, but never below $0. That’s because the lower the inverse ETF’s price, the percent change that the benchmark represents equates to a smaller point change in the ETF.

For example, a benchmark is at $100 and the 1x inverse ETF is $100. If the price of the benchmark moves up $2 to $102 in a day, that’s 2%. So, the ETF moves down 2% of $100—$2.00—to $98. If the benchmark on the following day moves up another 2%, $2.04 to $104.04, the ETF moves down 2% of $98—$1.96—to $96.04. The inverse ETF had a smaller price change on the second 2% drop than it did on the first, because the ETF’s price was lower. In that way the inverse ETF can never go below $0. Very clever. But that creates another problem.

The leveraged, inverse ETFs track the daily percentage price change of the benchmark. Those ETFs can sometimes move in ways that are counterintuitive because the prices of the leveraged and inverse are path-dependent. If the benchmark moves up $1.00 today, and down $1.00 tomorrow, that has a different impact on the ETF than down $1.00 today and up $1.00 tomorrow. Huh?

Connective Financial Tissue

Let’s look at two scenarios of a leveraged ETF that moves 2x the percent change of the benchmark, and an inverse ETF that moves -1x the percent change of the benchmark (Figure 1 below). Let’s assume that the benchmark and the leveraged or inverse ETFs start at $100.

In Scenario 1, the benchmark starts at $100 and moves up 1% on day 2 to $101. The leveraged ETF starts at $100, and moves up 2% to $102, and the inverse ETF moves down 1% to $99. When the benchmark drops $1.00 from $101 to $100 on day 3, that’s not quite 1%. That’s .99%. The price of the leveraged drops 2x .99%— 1.98% of $102—to $99.9802. The inverse rises .99% from $99 to $99.9802. Both the leveraged, inverse ETFs are a little lower than where they started—$100—while the benchmark didn’t change at all.

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FIGURE 1: A TALE OF TWO ETFS For illustrative purposes only.

In Scenario 2, the benchmark drops $1.00 on day 2, and the leveraged ETF drops 1% x 2 to $98. When the benchmark rises $1.00 back to $100 on day 3, that’s a 1.01% increase. The leveraged rises 1.01% x 2 to $99.9798. It doesn’t rise $2 back up to $100.

The inverse ETF exhibits similar behavior. That’s the nature of percentage price changes. 1% on a higher price is a bigger change than 1% on a smaller price. In both scenarios, the benchmark started at $100 and ended at $100, but the leveraged, inverse ETFs neither ended at $100, nor had the same ending value in the two scenarios. That’s why their prices are dependent on the specific price path of the benchmark.

Track Your Expectations

Now, I know what you’re thinking—does .02 between the benchmark and ETFs really matter when the market is moving around? OK, that’s a pretty small difference. But this is a simple scenario involving only three price changes. Imagine the difference that could accumulate over 260 trading days in a year. While the benchmark didn’t have a net change—it started at $100 and ended at $100—in the three price changes, the leveraged and inverse ETFs both lost value, and lost different values, depending on the path of the benchmark’s price changes.

That doesn’t mean there’s something wrong with the leveraged and inverse ETFs. That’s just how they work. Because the leveraged and inverse ETFs track the daily percent changes of the benchmark, the performance of those ETFs can be quite different than the percent changes in the benchmark over longer periods. That’s what a lot of investors can find confusing. It looks like the leveraged and inverse ETFs should have done one thing, but did another.

What does that mean for traders? Should you avoid trading leveraged and inverse ETFs long term, if at all? That’s for you to decide. All trading products present risk. But some have nuances that can surprise you if you don’t understand them. In the case of leveraged and inverse ETFs, their particular nuance is that the daily, percentage price changes create discrepancies to the benchmark’s longer-term performance. So, if you’re looking for an exact leveraged or inverse replica of the benchmark, you might not get that. Go in with an educated expectation, though, and the leveraged and inverse ETFs might provide opportunity.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.