If something looks too good to be true, it probably is—perhaps the investment version of this proverb might stipulate that anything with sky-high returns may have at least as much risk.
That actually oversimplifies the risks of some newer varieties of exchange traded funds, known as leveraged and inverse ETFs.
Leveraged ETFs strive to amplify the performance of—usually doubling or tripling—an underlying index by using derivatives and debt.1
That same qualifier applies to inverse ETFs: They strive to provide the effect of short-selling an index, also by using derivatives and debt.2
Some ETFs are both leveraged and inverse.
All told, leveraged and inverse ETFs accounted for $63 billion in assets in July, which is considerable given that they only debuted in 2006.3
Leveraged ETFs often include words like “ultra,” “bull,” “long,” “double,” or “triple” in their names. For inverse ETFs, it’s typically “bear,” “inverse” or “short.”
Inverse ETFs in particular may appeal to investors anticipating a market downturn, but they are not designed for those who want to buy and hold.
In fact, Morningstar said leveraged and inverse ETFs are only appropriate for less than one percent of those who invest.4
That small minority might be defined as those who trade professionally or otherwise have the ability to monitor the performance of their investments throughout the trading day with an appetite for volatility and tolerance for risk.
Like the Securities and Exchange Commission said in an investor alert on the topic, “…performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.”5
Issuers of these ETFs typically disclose that they are only designed to deliver their stated returns on a daily basis.
The leverage in these ETFs comes from margin that in most cases resets daily—although some are monthly.
That reset effectively compounds more interest onto the ETF holding.
And when the markets increase in volatility, so can the pace at which the size of the margin position grows.6
It can grow even faster if the stated amplification of the ETF is triple, rather than double.
This is why leveraged and inverse ETFs are typically only recommended for professional investors and draw a following from speculators.
1 Investopedia, “Leveraged ETF,” Investopedia.com, 2015.
2 Investopedia, “Inverse ETF,” Investopedia.com, 2015.
3 Shriber, Todd, “Inverse, Leveraged ETF Assets Reach a Record $63 Billion,” ETF Trends, July 8, 2015.
4 Justice, Paul, “Warning: Leveraged and Inverse ETFs Kill Portfolios,” Morningstar, January 22, 2015.
5 U.S. Securities and Exchange Commission, “Leveraged and Inverse ETFs: Specialized Products With Extra Risks for Buy-and-Hold Investors,” SEC.gov, August 18, 2009.
6 “Leveraged and Inverse ETFs: Why 2x Is Not the 2x You Think,” ETF.com, 2015.
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Leveraged and inverse exchange traded funds are unique and involve additional risks and considerations not present in traditional products. Leveraged products are often identified with a multiplier in their names, such as 2x or 3x, or may have a fund-specific description such as ultra. These funds are designed to double or triple the performance of a particular index over a stated period of time. Similarly, inverse or short products are designed to deliver the opposite return of an index, or, in the case of a leveraged inverse fund, a multiple of the opposite return of the index. Because the products reset over short periods of time, they are designed to deliver their stated returns only for the length of their reset periods. Most leveraged and inverse ETFs and ETNs currently reset on a daily or monthly basis and are therefore designed to deliver their stated returns for the reset period only (i.e., one day or month).
ETFs have unique features that you should be aware of, which can include distribution of any gains, risks related to securities within the portfolio, and tax consequences. The data quoted herein represents past performance and is not indicative of future results. The investment return and principal value of an investment will fluctuate so that your investment, when redeemed, may be worth more or less than their original value. Current performance may be lower or higher than the performance data provided.
For additional information regarding the risks associated with leveraged and inverse ETFs, please access the Support page to review the FINRA Investor Alert on Leveraged and Inverse ETF’s Risks (http://www.finra.org/investors/protectyourself/investoralerts/mutualfunds/p119778), and SEC Investor Education: ETFs (http://www.sec.gov/investor/alerts/etfs.pdf)
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