What you need to know before you invest in leveraged or inverse ETFs

By Shawn Levine, Exchange Traded Funds Analyst

Leveraged and inverse ETFs may have a place in investor portfolios, but the risk must be understood.

Over the past few years, leveraged exchange-traded funds (ETFs) have come under scrutiny and caused concern for investors who feel the products have not performed in line with expectations. Leveraged ETFs seek to magnify (usually by two or three times) the daily returns of an index or commodity by employing leverage (generally speaking, the use of borrowed funds; but in this case, these products use derivatives to create leveraged exposure).

Magnifying potential returns and risk

The daily rebalancing mechanism is a very important concept to understand and is best explained with an example. Suppose two investors want to take a view on the S&P/TSX 60 Index, which is trading at $100 for simplicity’s sake. One investor buys a two-times leveraged S&P/TSX 60 Bull ETF, while the second buys units of the inverse two-times leveraged S&P/TSX 60 Bear ETF. Both take $100 positions.

The next day, the S&P/TSX 60 moves up 10% to $110. Ignoring fees and transaction costs, holdings in the Bull ETF jump 20% to $120 while holdings in the Bear ETF fall 20% to $80. In order to maintain twice the exposure to the underlying index, the Bull ETF will increase the amount of derivatives to create $240 of exposure. The Bear ETF will decrease the amount of derivatives to create $160 of exposure.

Suppose the following day, the index declines 9.1% to $100. Doubling that move, the Bull ETF declines 18.2% to $98.16, and the position in the Bear ETF gains 18.2%, rising to $94.56.

Both investors have lost money, and that is before factoring in fees. Over periods longer than one day, the effect of compounding can have a dramatic effect on returns. In periods where the underlying asset trends in one direction with little volatility, compounding will work in the investor’s favour; the leveraged ETF will return more than 200% times the return of the underlying asset. And in contrast, what happens when the underlying asset or index fluctuates up and down in value?

Managing the risks

To mitigate these factors, investors should frequently adjust their exposures back to the original dollar investment. This means that if your position moves up in value, you should sell some of the leveraged ETF units (and vice-versa if it moves down). However, the drawback of this approach is that you incur the cost and inconvenience of frequent rebalancing and may have to sit on idle cash or seek other vehicles for reinvestment. Without regular rebalancing, the longer you hold leveraged ETFs, the more likely it is that your returns will deviate from the underlying index or commodity.

The benefits of leveraged ETFs

Despite their drawbacks, leveraged ETFs do have some advantages. Leveraged ETFs offer non-recourse leverage, which means that you will never lose more than your initial investment. This is in contrast to traditional leveraged investments, where you have borrowed to invest and you can lose your initial investment and be liable for the borrowed portion.

Second, two-times leveraged ETFs offer a way to achieve daily market exposure to a specific index with half the invested capital. Therefore, a $0.50 investment in a leveraged ETF will provide approximately the same daily performance as a $1 investment in a traditional ETF. The “liberated” $0.50 can be used to seek out other investments, preferably in uncorrelated asset classes.

Inverse ETFs

Single-inverse ETFs can be used in a multitude of scenarios, a major one being to hedge an existing position. Suppose you are currently long a diversified basket of Canadian equities but feel that the six-month outlook for the equity market is grim. Rather than selling the existing positions (which may not be desirable for various reasons such as tax concerns), you can use an inverse ETF on the S&P/TSX 60 to partially hedge the market exposure.

In addition, inverse ETFs can be used to take a general view that the broad market or a specific sector will decline, limiting the need for stock-picking. Inverse ETFs possess advantages over short-selling, including no requirements for margin and limited loss potential.

Inverse ETFs reset their exposure daily to ensure that the daily performance of the ETF closely replicates the inverse of the daily performance of the underlying index or commodity. As such, volatility can cause actual returns for single-inverse ETFs to differ from expectations.

Know what you’re getting into

Leveraged and inverse ETFs may have a place in investor portfolios, but the risks must be understood. Inverse ETFs can be effective hedging tools when used appropriately. While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that should be monitored very closely to determine if frequent rebalancing is required. Since these products seek to return a multiple of the daily percentage return of the index or commodity, they are most suitable for taking short-term views on a particular market or sector and may not align well with a buy-and-hold strategy.

The information contained herein is current as of July 15, 2010.

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