Leveraged and inverse ETFs and ETNs are types of ETPs, or exchanged-traded products, that
seek to provide a multiple and/or the opposite performance of a certain index or benchmark.
For example, an investor might buy a leveraged ETP in an attempt to potentially boost returns
on a stock index they think will go up or an inverse ETP in an attempt to provide a
short-term hedge to their portfolios if they anticipate a falling market.
While the concept may sound simple, leveraged and inverse ETPs are complex and are subject
to significant risks.
Before using these products, investors should understand what they’re designed to do,
what risks they carry, and that these products are not suitable for most investors.
Let’s start with leveraged ETPs.
Leveraged ETPs seek to provide double, triple, or quadruple the returns of an underlying
index for one day.
The amount of leverage is commonly indicated by their names, which often include terms
like 2x, 3x, 4x, or ultra.
These ETPs primarily provide the leverage needed by entering into an agreement called
a swap with large investment banks but may also use futures and options contracts
traded on a particular stock index they want to emulate.
For example, let’s say we have a leveraged ETP that seeks to produce twice the returns
of a stock index’s daily performance.
For easy math, we’ll say that the ETP is trading at $100 per share and the underlying
index is at 10,000.
If the index rises 10% to 11,000, shares of the ETP will theoretically rise about 20%
from $100 to $120 for a gain of $20 per share.
Note, it is the two times leverage factor that provides this extra return.
However, if the index falls back to 10,000, or 9.09%, the ETP will likely fall twice as
much, or 18.18%, pushing the price down to $98.18 per share for a loss of almost $22
per share.
As you can see, the leverage led to large gains and then large losses, and the ETP ended
up lower than the starting price even though the index ended where it started.
Now let’s look at inverse ETPs.
Inverse ETPs seek to provide returns opposite of the underlying index.
The names of these products may include terms like short or bearish.
Here’s an example of how this works.
We’ll assume the ETP is trading at $100 per share and the underlying index is at 10,000.
If the index falls 3%, or 300 points, to 9,700, the ETP should rise 3% to $103 per share.
If the index rises 3%, the ETP should fall 3% to $97 per share.
Additionally, inverse ETPs may also be leveraged ETPs, magnifying the potential gains and losses.
It’s important to realize that leveraged and inverse ETPs are only designed to achieve
this performance over a fixed period, typically a day.
This means that unlike more traditional ETPs, leveraged and inverse ETPs are not designed
to be held overnight or used as long-term buy-and-hold investments.
One reason for this is that at the end of the trading session, these ETPs reset
their investment strategies in order to maintain their leverage ratio.
For example, if the index goes up in value, the ETP will have to increase its exposure
to the index for the next day in order to get the right multiple.
Resetting can result in a difference in the returns of the ETP compared to the underlying
index.
The resetting difference could compound losses or even cause losses despite the underlying
index moving in the desired direction, especially in volatile markets.
Furthermore, in lightly traded markets (such as VIX futures), the resetting of leverage
and inverse ETPs has itself contributed to increased volatility.
Another way that price volatility can lead to losses is if major movements in the underlying
index are so extreme that the losses result in the leveraged ETP falling below a fund’s
preset minimum value.
If this happens, the leveraged ETPs may be forced to close.
Fund closures can lead to major losses for investors.
Closure can be particularly complex for ETNs, which are structured differently than ETFs.
While it may feel a bit like alphabet soup, it’s important to understand how ETNs are
created and how market volatility could lead to an ETN being closed.
Unlike an ETF, which provides ownership in a basket of securities, an ETN is actually
a debt instrument issued by a financial institution and structured more like a bond.
Instead of interest payments, the ETN promises returns linked to an underlying index over
a certain period of time and to return the principal at maturity, usually 20 to 30 years
out.
This structure allows ETNs to very closely track the performance of their underlying
index but also comes with additional risks.
First is credit risk.
If the financial institution issuing the ETN fails, investors may only be entitled to receive
pennies on the dollar or lose their entire investment.
There’s also closure risk.
Some ETNs may be called before maturity.
The process of calling the note is known as an accelerated redemption, which allows
the issuer to close the ETN and return the value of the note, if any, to investors after
a certain date.
If the value of the note has dropped, investors can experience losses.
However, not all ETNs allow accelerated redemption.
Instead, market conditions may force the issuers to delist ETNs from a national exchange, making
it difficult for investors to liquidate their position.
Investors may be forced to either wait for the note’s scheduled maturity, which could
be decades away, or try to sell their shares in the over-the-counter market, likely at
a substantial loss.
So, with these risks in mind, what should you do if you want to trade a leveraged or
inverse ETP?
First, make sure you understand the product and its goals and check to see if it meets
your objectives and risk tolerance.
Also, familiarize yourself with the ETP’s call features and maturities, and its costs
and fees.
All of this can be found in the prospectus and the pricing supplement, which also contains
a history of whether the ETP has traded at a premium or a discount to its underlying
net asset value.
You should also check the product’s bid-ask spread because wider spreads could make it
difficult to get a trade filled at your desired price.
If you’re investing in a taxable account, you may want to review the product’s history
of distributing capital gains.
Although ETFs are usually tax-efficient, certain strategies may result in a higher tax burden
than other types of ETFs.
Be sure to contact a qualified tax advisor about your particular circumstances.
Next, check with your broker to see what rules they have around trading leveraged and inverse
ETFs and ETNs.
Some brokerages will require you to sign an agreement acknowledging the risks.
Finally, determine your entry and exit strategies before placing the trade.
Have a plan for what you would do if the trade goes badly to avoid large losses.
Remember, if you do decide to hold a leveraged ETP longer than a day, you may not get the
returns you expected.
You may even experience a loss despite the underlying index moving in a favorable direction.
Leveraged and inverse ETPs are complex products that require caution.
Take time to familiarize yourself with the benefits and risks of these investments.