The Lowdown on Leveraged and Inverse Exchange-Traded Products

Exchange-traded products (ETPs), including exchange-traded funds (ETFs), commodity pools and exchange-traded notes (ETNs), are a popular way to invest, with thousands of different products available to target almost every imaginable investment objective. With such a wide variety of products available it’s important to remember that not all ETPs are the same.

Leveraged and inverse–often collectively referred to as “geared”–ETPs don’t work the same way as simpler one-to-one tracking ETPs. These are complex investments that come with a unique set of risks. (While the focus of this Insight article is on geared ETPs, there are geared mutual funds as well, which are similar.)

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What are geared ETPs?

Geared ETPs typically seek to deliver set positive or negative multiples of the performance of a given benchmark or index over a given time period such as one day or one month. Among most of the currently listed geared ETPs, positive leverage factors are 1.5x, 2x, and 3x (that is, one-and-one-half, two and three times) and inverse factors are -0.5x, -1x, -2x and -3x. The vast majority of geared ETPs have a daily leveraged or inverse objective and reset their exposure factors each day. This means that the stated leverage or inverse factor objective they seek to provide is restricted to a single trading day, generally measured from the close of trading from one day to the close of trading on the next day.

The objective of a geared ETP with a daily reset is to provide that degree of leveraged or inverse exposure for that single period and, importantly, not over longer (or shorter) periods. (Similarly, a geared ETP with a monthly objective is designed to provide that leveraged or inverse exposure for a specified monthly period.) Holding a geared ETP for a period that is shorter or longer than its objective can lead to performance that may deviate significantly from the daily objective.

One geared ETP example is a leveraged ETF with a 2x daily objective that aims to deliver twice the return–positive or negative–of the S&P 500 on a given day. If the S&P 500 gains 2 percent in a day, the product would aim to deliver a gain of 4 percent. Such a product is not designed to provide twice the return of the index over longer periods, however.

Another example is an inverse ETF that seeks to deliver -1x, or the opposite, of the performance of the Nasdaq 100 Index. This ETF aims to deliver a return that is exactly the opposite of what the index returns (whether positive or negative) on a given day. If the Nasdaq 100 closes up 1.5 percent, the inverse ETF would aim to return a loss of 1.5 percent. If the index closes down 2 percent, the ETF should return a gain of 2 percent.

Some inverse ETPs seek to deliver a multiple of the opposite of a given index’s performance, usually -2x or -3x, over a given time period. An example of such a product is an ETF that seeks to deliver -3x of the daily return of the NYSE FANG+ Index. If the FANG+ index falls 3 percent on a given day, investors in the ETF can expect gains equivalent to three times the index’s percentage loss, or 9 percent. On the other hand, if the index gains 3 percent in a day, the ETF should return a loss of 9 percent.

To achieve their stated returns, leveraged and inverse ETPs often use a range of investment strategies, including swaps, futures and other derivatives in addition to possible long or short positions in securities. Note that geared ETNs, which provide similar leveraged and inverse exposures, do not hold any underlying portfolio of assets but instead are debt issued by a financial institution.

Since most geared ETPs are only designed to accomplish the stated leveraged or inverse objective on a daily basis, they don’t make any promises as to how their returns will compare over a longer period. Returns can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark over the same period of time, which can make these products risky long-term–or even medium-term–investments, especially in volatile markets. While such products can be held for periods that don’t align with the stated objectives, generally such positions should be monitored closely and used by investors who understand what the products are designed for and how they can behave in different market environments.

A closer look

Let’s say that, as of the close of trading on Monday, you have one $100 share of a 2x ETP pegged to an index with a value of 100. At the close of trading on Tuesday, the index is down 10 percent to 90, resulting in a 20 percent loss for the ETP, bringing its value down to $80. Then, on Wednesday, the index closes up 10 percent at 99, resulting in a gain of 20 percent for the ETP. However, 20 percent of $80 is just $16, meaning the ETP’s value is now at $96.

On both days, the ETP achieved its stated objective and produced daily returns that were two times the daily index returns. But over the course of these days the index lost just 1 percent, while the 2x leveraged ETP lost 4 percent. That means that over just a couple of days, the ETP lost four times as much as the index, not just two times (representing actual leverage of four times rather than two times). This is not “tracking error,” however, since the ETP met its daily objective.

Things to consider

Some ETPs, such as geared ETPs, can be complicated. Before investing, be sure to ask:

How does the ETP achieve its stated objectives? And what are the risks? Ask about–and be sure you understand–what the products are designed to do and how they may behave in different market environments (for example, in a volatile market), as well as the techniques the ETP uses to achieve its goals and the risks they involve.
What happens if I hold a geared ETP longer than one trading day? While there may be trading and hedging strategies that justify holding leveraged and inverse ETPs longer than a day, investors with an intermediate or long-term time horizon should carefully consider whether these products are appropriate for their portfolio. You could suffer losses even if the longer-term performance of the underlying index is up for a leveraged ETP or down for an inverse ETP.
Is there a risk that a geared ETP will not meet its stated daily objective? There is always a risk that not every leveraged or inverse ETP will meet its stated objective on any given trading day. Be sure you understand the impact this could have on the performance of your portfolio, taking into consideration your goals and your risk tolerance.
What are the fees and expenses? Leveraged or inverse ETPs may be more costly than traditional ETPs. Use FINRA’s Fund Analyzer to estimate the impact of fees and expenses on your investment.
What are the tax consequences? Leveraged or inverse ETPs may be less tax-efficient than traditional ETFs, in part because daily resets can cause the ETP to realize significant short-term capital gains that may not be offset by a loss. There may be additional tax-related issues, so it is important to check with your tax advisor about the consequences of investing in these products.

The bottom line is that not all ETPs come with the same risks, and not every ETP is right for every investor. Only invest if you are knowledgeable of and comfortable with the risks associated with these specialized products.

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