Investor Watch: Inverse and leveraged ETFs

What do I need to know about exchange traded funds (ETFs) in general?

The term exchange traded funds is used to describe a category of products, some very risky, some not so risky.

Before making a decision to invest in an ETF, you need to find out what kind of ETF is being proposed. If you are considering a “leveraged” or “inverse” ETF, make sure you understand just how risky that might be.  There are 15 leveraged ETFs and 19 inverse1 ETFs trading in Canada today.

Leveraged and inverse ETF products are better suited to professional investors than they are to retail investors. Professional traders use these short-term trading vehicles to speculate, or to hedge other positions they hold.

Leveraged ETFs promise the possibility of double or triple the returns of an index or a commodity on a daily basis. An index is simply a basket of investment products.  Inverse products promise the reverse of the return of an index on a daily basis.  Some inverse ETFs promise double or triple the reverse of the return of an index.  If prices on the market go up and down over time, you will lose money on these products whether you buy a leveraged or inverse ETF, if you hold it for any length of time.

Conventional index ETFs are set up to replicate an index.  Retail investors who wish to hold a diversified portfolio for a long time may choose to use these ETFs for longer term investing.  Index ETFs may track a broad market index like the Standard and Poors 500 or narrower indices focused on various sectors, commodities or countries.

What you should do before investing in leveraged or inverse ETFs?

Before investing in leveraged or inverse ETFs, you need to do some research to understand where the ETF derives value from and how it invests to earn a return.  Remember that borrowing or using other leverage can make a safe investment risky and a risky investment dangerous. 

Understanding these facts can help you identify some of the risks in investing in leveraged and inverse ETFs.  Knowing the risks of an investment before you buy it is the key to making an informed investment decision.

To learn more about a particular ETF you are considering, go to www.sedar.com and go to Company Profiles, then go to Investment Fund Groups.  Once you find the name of your fund company, you will get a list of all their funds.  When you choose the fund you are considering, you get access to all publicly filed disclosure documents by clicking on the link called “View This Investment Fund’s Documents”.  These documents include the prospectus, financial statements and reports.  Focus primarily on risk factors in the prospectus.

Background

An ETF, or exchange-traded fund, is a basket of underlying investments, whose shares trade on an exchange like the Toronto Stock Exchange (TSX). 

What should I know about leveraged and inverse ETFs?

  1. What is a leveraged ETF?  A leveraged ETF is designed to return a multiple of the daily performance of the underlying index.  The manager of the ETF forms a fund based on an underlying index and then borrows against securities in the fund or uses derivatives to enhance the return of the index.  If the underlying index goes up by 2% one day, a leveraged ETF aiming for two times the return of the index should go up 4% that day.
  2. What is an inverse ETF?  An inverse ETF aims to achieve the opposite of the daily performance of the underlying benchmark.  The managers use various derivatives to profit from a decline in the value of an underlying benchmark. Inverse-leveraged ETFs aim to return a multiple of the opposite of the daily performance.  If the underlying index goes up by 2% one day, an inverse ETF should go down by 2% that day.  An inverse-leveraged ETF aiming for two times the reverse of return of the index should down 4% that day.
  3. What is the effect of daily re-balancing and compounding?  Both leveraged and inverse ETFs re-balance and compound daily.  As a result, returns over periods of longer than one day, especially in periods of market volatility, may be completely unrelated to the return on the underlying index for the same period and may even move in the opposite direction to the underlying index.  If there is significant market volatility, these leveraged and inverse products can lose money no matter which way the market moves over time.

Two real life examples show how the daily focus of these funds combined with a volatile underlying index can yield surprising results:

  • A leveraged fund that aimed to return 2 times the daily return on the U.S. Oil and Gas Index, lost 6% during a year when the index itself rose 2%.  
  • An inverse fund that aimed to return 2 times the inverse of the return on the U.S. Oil and Gas Index, lost 26% (not 4%) during the same year. 

What are the risks of leveraged and inverse ETFs? 

There are a number of risks associated with investments in leveraged and inverse ETFs.

  • Leverage risk – Both leveraged and inverse ETFs borrow directly against investments in the fund or use derivatives to accomplish their objectives.  Using leverage either directly through borrowing or by trading in derivatives can cause magnified losses during adverse market conditions.
  • Price volatility risk – The prices of leveraged and inverse ETFs fluctuate much more widely than prices of conventional index ETFs, because of the use of leverage and daily re-balancing and compounding. 
  • Counterparty risk – When leveraged and inverse ETFs use derivatives, they are exposed to risk that the person providing the derivative may default.  If that person fails to perform the obligations under the derivative contract, the value of the investment may decline, no matter what the underlying index has done.
  • Transparency risk – Unlike a conventional index ETF where the securities making up the index are always known by looking at the underlying index, leveraged and inverse ETFs are not so transparent.  The use of derivatives can make the composition of these ETFs very unclear.
  • Fee risk  – Leverage and inverse ETFs have much higher management expense ratios (MERs) than other ETFs because they are not just following an index but actively managing a variety of investments, including derivatives.  The MER on an ETF based on the TSX-60, for example, is 0.17%.   The MER on a leveraged ETF may be 1.15%, almost 7 times as much.  MERs have a huge impact on your return over time.

1 The 19 inverse ETFs are comprised of 4 ETFs that offer the opposite of the daily performance of an underlying benchmark and 15 ETFs that offer two-times the opposite of the daily performance of an underlying benchmark.