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What are inverse and leveraged Exchange Traded Funds (ETFs)?

Inverse and leveraged exchange traded funds (ETFs) are a risky form of ETF.  See Investright's Exchange traded fund page to find out about traditional ETFs. A leveraged ETF is designed to return a multiple of the daily performance of the underlying index. An inverse ETF aims to achieve the opposite of the daily performance of the underlying benchmark. 

Professional traders use inverse and leveraged ETFs to speculate or hedge other positions they hold. For that reason, they are better suited to professional investors. Some leveraged ETFs promise the possibility of doubling or even tripling the returns of an index or commodity on a daily basis. Some inverse products promise the reverse of the return of an index on a daily basis. There are even inverse leveraged ETFs that promise double or triple the reverse of an index's return.  Unlike regular ETFs, inverse or leveraged ETFs do not hold actual stocks. They hold derivatives that mimic the performance of the indices they track. If prices are volatile and go up and down over time, investors may lose money on both of these products if they hold them for any length of time.

What risks do inverse and leveraged ETFs have?

Five reasons why inverse and leveraged ETFs are risky:

• Leverage risk: using leverage can cause magnified losses in adverse markets 
• Price volatility risk: prices fluctuate more widely than prices of conventional ETFs because of the use of leverage and daily re-balancing and compounding 
• Counterparty risk: use of derivatives exposes the investor to risk if the derivatives default 
• Transparency risk: inverse and leveraged ETFs are not very transparent because of the use of derivatives 
• Fee risk: these ETFs have much higher management expense ratios (MER) because they are actively managing a variety of investments, including derivatives. MERs have a huge impact on returns over time

Can you sell them easily?

Yes. You can sell ETFs at current market prices at any time during the trading day.

What are the costs?

There is a transaction cost for each trade. The MER of these ETFs are considerably higher than the MERs of regular ETFs.  The higher the MER, the more the fund will have to earn in order for you to make money.

What are the expected types of returns?

Inverse and leveraged ETFs can pay large returns. They are much riskier than basic indexed ETFs, so they can also result in significant losses when the market is has frequent movement either up or down.

To understand the discrepancies between unleveraged and leveraged investment results, let’s take a look at an unleveraged fund and a leveraged fund that are both trading for $100.

The following table illustrates the gains and losses for different ETF products based on the same index movements. Notice that for a double inverse ETF, the loss is 40% of the initial investment even though the index has gone up only 3% during the same period of time. The daily rebalancing nature of leveraged and inverse ETFs makes these products unsuitable to hold for more than 1-2 days.