Leveraged and Inverse ETFs – Definition and Comparison

Leveraged and inverse ETFs might pique your interest if you want to take your investments up a notch or explore new strategies. Leveraged ETFs offer the potential for amplified returns, while inverse ETFs allow you to profit from declining markets. 

But before diving in headfirst, let’s delve into what exactly leveraged and inverse ETFs are, how they differ, and the risks involved. 

What Are Leveraged ETFs?

Leveraged ETFs, also known as “geared” or “double exposure” ETFs, are a type of exchange-traded fund that aim to magnify the returns of an underlying index. How do they achieve this? Using financial derivatives and borrowed capital that increases their exposure to the assets they track.

Here’s how it works. If you invest in a leveraged ETF that aims to provide twice the daily return of its benchmark index, and the index goes up by, say, 1%, you would expect your leveraged ETF to go up by approximately 2%. This can entice investors who are looking for potentially higher gains than traditional ETFs.

However, it’s important to note that leverage is a double-edged sword. While it can amplify your profits when markets move in your favor, it can also intensify losses when things don’t go as planned. The performance of leveraged ETFs is typically calculated daily, which means their long-term results may not always align with expectations due to compounding effects.

What Are Inverse ETFs?

Inverse ETFs are a unique type of exchange-traded fund that allows investors to profit from the decline in value of an underlying asset or index. Unlike traditional ETFs, which aim to track an asset’s or index’s performance, inverse ETFs seek to generate returns that are inversely related to the movement of their underlying benchmark.

These innovative investment instruments achieve their objective by using derivatives and other financial instruments to “short” the target asset or index. This means that if the underlying benchmark goes down in value, the inverse ETF will rise in value (and vice versa).

Investing in inverse ETFs can be attractive for those who believe that specific sectors, industries, or markets may experience a decline. It allows them to benefit from such declines while potentially reducing overall portfolio risk.

However, investors need to understand that inverse ETFs come with certain risks. These include tracking errors, liquidity concerns, and potential losses due to compounding effects over time.

Leveraged vs. Inverse ETFs

Leveraged ETFs, as the name suggests, aim to magnify the returns of an underlying index or asset. They achieve this by using financial derivatives and debt instruments. 

On the other hand, inverse ETFs seek to provide returns that move in the opposite direction of an underlying index or asset. These types of funds use derivatives such as swaps and futures contracts to achieve their objective. 

While both leveraged and inverse ETFs can offer potential benefits for traders looking for amplified returns or hedging strategies, they also come with increased risks compared to traditional ETFs. Before investing in either type of fund, it’s important for investors to thoroughly understand how they work and carefully evaluate their risk tolerance level.

Risks of Leveraged and Inverse ETFs

One significant risk associated with leveraged and inverse ETFs is volatility. These types of funds typically aim to replicate multiple times (2x or 3x) the daily performance of an underlying index or asset class. This amplification magnifies both gains and losses, making them much more volatile than traditional ETFs.

Leveraged and inverse ETFs also face what is known as “decay” or “compounding” risk. Due to their daily rebalancing process, these funds may experience a loss over time, even if the underlying index remains relatively stable. This decay effect can erode long-term returns, especially during periods of high market volatility.

Furthermore, investors must be aware that leveraged and inverse ETFs are designed for short-term trading strategies rather than buy-and-hold investments. Their complex nature makes them ill-suited for long-term investment goals such as retirement planning.

Liquidity risk should not be overlooked when considering these types of funds. Some leveraged and inverse ETFs may have lower trading volumes compared to traditional ones, leading to wider bid-ask spreads and potentially higher transaction costs.

Examples of Leveraged and Inverse ETFs

There are several examples worth mentioning when it comes to leveraged and inverse ETFs. Let’s start with leveraged ETFs first.

One popular example is the ProShares Ultra S&P 500 (SSO). This ETF aims to provide investors with twice the daily return of the S&P 500 index. So if the index goes up by 1%, SSO should go up by 2%. On the flip side, if the index drops by 1%, SSO would be expected to decline by approximately 2%.

Another example is Direxion Daily Financial Bull 3X Shares (FAS), which seeks to deliver three times the daily return of financial companies in the Russell 1000 Index. It offers the potential for amplified gains but also amplifies losses.

Now let’s move on to inverse ETFs. One prominent example is ProShares Short QQQ (PSQ), designed to give investors a single-day inverse exposure to the NASDAQ-100 Index. If this index declines by, say, 2% during a trading day, PSQ should theoretically increase by around 2%.

The ProShares UltraShort Dow30 (DXD) is another notable inverse ETF that aims for twice the inverse exposure to the Dow Jones Industrial Average. When this index falls by 1%, DXD should rise by approximately 2%.

Remember, these are just a few examples among many leveraged and inverse ETFs available in today’s market. It’s crucial for investors considering these products to thoroughly research each one before making any investment decisions due to their unique characteristics and risks.

Conclusion

Leveraged and inverse ETFs can be powerful tools for investors looking to amplify their returns or profit from a decline in the market. However, they also come with significant risks that should not be overlooked.

Before investing in leveraged or inverse ETFs, it is important to thoroughly understand how they work and carefully consider your investment goals and risk tolerance. These types of ETFs are best suited for experienced traders who can actively monitor their investments and make informed decisions based on market conditions.

Remember, no single investment asset is suitable for everyone. It’s important to diversify your portfolio across different asset classes and consider all factors before making any investment decision.