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How much leverage is a good thing?
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When you’re investing, taking risks can bring rewards—or losses. Inverse and leveraged exchange-traded funds (ETFs) are very risky investments that can amplify returns but can compound losses if the markets go against you.
Inverse and leveraged ETFs are niche trading vehicles for short-term trading. They have daily return objectives and, in general, are not for buy-and-hold investors.
Many leveraged, inverse, and leveraged inverse vehicles are not ETFs but rather are exchange-traded notes (ETNs) that often are lumped together with ETFs. ETNs are debt instruments and subject to counterparty risk—the possibility that the other party in an investment or transaction may default on the obligation.
Key Points
- Leveraged ETFs seek to magnify the return of a benchmark, while an inverse ETF seeks to have the opposite return of an index.
- These ETFs have daily performance objectives; over the long term, their performance can deviate widely from the stated multiple of the performance.
- These investments are for sophisticated investors comfortable with risk.
What are leveraged and inverse ETFs?
First off, knowing how traditional exchange-traded funds work helps to understand how leveraged and inverse ETFs function. A traditional passive ETF seeks to track the price of an index, such as the S&P 500. The price of the ETF goes up and down at roughly the same pace as the index by owning the same securities as the index. If the Nasdaq 100 goes up 1%, for example, an ETF tracking that index, such as the Invesco QQQ (QQQ), rises by the same percentage.
A leveraged ETF amplifies those gains or losses. These types of ETFs may attempt to create returns that are two, three, or even 10 times the return of an underlying index. Fund companies issuing the leveraged ETF won’t own the underlying securities of the index, but will often use options contracts to amplify the return.
An inverse ETF, sometimes called a short ETF, seeks to profit when the price of a benchmark falls. These ETFs often use futures contracts, swaps, or other derivatives to try to meet the daily return objectives. These can offer short-term portfolio hedges against declines, and are easier to use than creating a margin account for short selling.
A leveraged inverse ETF combines these two strategies into one ETF, seeking to amplify the return when an index drops. These funds are highly speculative.
There are leveraged ETFs and inverse ETFs in most sectors, including:
- Equity indexes such as the ProShares UltraPro QQQ (TQQQ), a three-times leveraged ETF, or ProShares Ultra S&P 500 (SSO), a two-times leveraged ETF.
- Single stocks, like GraniteShares 2x Long NVDA Daily ETF (NVDL), based on chipmaker NVIDIA (NVDA), or Direxion Daily TSLA Bear 1x Shares (TSLL), which tracks electric vehicle maker Tesla (TSLA).
- Fixed income, like Direxion Daily 20-Year Treasury Bull 3x Shares (TMF) or ProShares Ultra 7–10 Year Treasury (UST), a two-times leveraged ETF.
- Commodities, such as Direxion Daily Energy Bull 2x Shares (ERX) or DB Gold Double Short Exchange Traded Notes (DZZ), a two-times leveraged inverse ETN.
- Currencies, like ProShares UltraShort Euro (EUO), a two-times leveraged inverse ETF, or ProShares Ultra Yen (YCL), a two-times leveraged ETF.
How leveraged and inverse ETFs work
These ETFs are best used as short-term trading vehicles, not long-term buy-and-hold positions. Although these ETFs have stated objectives, there can be a significant difference between the expected return and actual performance over the long term.
Slippage: It’s a drag!
Slippage is the industry term for the transaction costs and logistical inefficiencies that drag down the performance of a fund or strategy relative to its benchmark. For leveraged and inverse ETFs and ETNs, here are two of the big culprits:
- Option theta. If a fund uses long options to mirror the performance of a security, the time decay or “theta” of the options can work against you.
- Roll yield. Futures traders know that different contract delivery months trade at different prices. When plotted to a curve, prices may either be in contango (upward sloping) or backwardation (downward sloping). Depending on the fund’s strategy, roll yield can either be a drag or a partial tailwind.
Either way, using derivatives in an ETF will raise the transaction frequency, and thus the cost to operate.
Leveraged ETFs seek to magnify the daily return of an index, whether it’s by two, three, or 10 times (or the inverse). In dollar terms, that means that for each dollar invested the goal is to return $2, $3, or $10 compared to the daily performance of the index.
At the end of each trading day, the most inverse and leveraged ETFs “reset” to that day’s settlement price, and the next day, the ETF seeks a return that corresponds to its leveraged and/or inverse objective.
If a fund is held beyond a day, the return is a compound of daily leveraged returns based on how long the investor owns the fund.
The Securities and Exchange Commission (SEC) uses this example to show how a two-times leveraged fund works on a down day and then on an up day:
- On day 1, a stock index value starts at 1,000. A leveraged ETF that seeks to double that return also starts at $1,000.
- If the index ends the first day down 100 points, it has lost 10%, falling to 900. The leveraged ETF loses 20% and is down to $800.
- On day 2, if the index rises 10%, it is now at 990. The ETF rises 20%, so its value is $960 (adding 20% of the starting value of $800).
“Most leveraged and inverse ETFs reset each day, which means they are designed to achieve their stated objective on a daily basis. With the effects of compounding, over longer time frames the results can differ significantly from their objective.” —FINRA guidance on non-traditional ETFs
Even when the ETF rebounds on the second day, the return is lower than the index because the fund has to recoup its gains from a lower level. The longer an investor holds the fund, the more their leveraged returns deviate from the index’s nominal performance. If you hold it for a day, a leveraged ETF will track the index accordingly. But if you hold it for a week, a month, or year, your return profile can deviate greatly from the weekly, monthly, or annual return of the underlying benchmark due to the “daily reset” nature of these ETFs.
Who should (or shouldn’t) use leveraged or inverse ETFs
Leveraged and inverse products are designed for trading, not investing. These products might be appropriate for someone who:
- Understands and accepts the potential for steep losses.
- Is familiar with the concept of shorting an investment and the risks involved.
- Accepts that the daily reset can significantly impact longer-term performance.
- Can manage a position—the amount of stock or other investment held—on a daily basis.
If you can’t tolerate losing a lot of money in a short time or don’t understand how these funds operate, they are not for you.
The bottom line
As with any investment, it’s important to know what you own. That involves reading the prospectus to understand how it seeks to achieve its objective and what the risks are. With leveraged and inverse products, the risks are substantial.
Further, these funds are typically much more expensive to hold than other ETFs, and they can be less tax efficient because the daily calculation and reset may cause short-term capital gains, meaning they are taxed at the same level as ordinary income.
This article is intended for educational purposes only and not as an endorsem*nt of a particular financial strategy, company, or fund. Encyclopædia Britannica, Inc., does not provide legal, tax, or investment advice. Please consult your legal or tax advisor before proceeding.
