Leveraged and Inverse ETFs 101 September 12, 2022

Key Takeaways

• Leveraged ETFs are ETFs that multiply returns of their underlying indices, whereas inverse ETFs provide returns in the opposite direction of their underlying indices.
• L&I ETFs are structured in such a way that they are meant for active trading rather than buy-and-hold purposes. Holding these ETFs for a longer-term period will expose investors to further risk, as their performance will deviate from their investment objectives.
• L&I ETFs are like double-edged swords. They can provide an additional option for investors to gain exposure to market themes and opportunities but incorrect usage may result in losses for investors.

What is an ETF?

Exchange-Traded Funds (ETFs) are open-ended investment funds listed and traded on stock exchanges. An ETF is a basket of securities that aims to track, replicate or correspond to the performance of an underlying index or assets.

A single ETF can give an investor exposure to multiple equities, an entire market sector, or even securities from one particular country. An ETF covers a broad range of stocks through just one instrument, providing investors with flexibility and diversification of portfolios. They trade on exchanges with full price transparency, just like stocks.

However, there are special classes of ETFs available in the market that allow investors to leverage or short their investment directly without the need to deposit a margin or borrow stocks respectively.

These unique types of ETFs are called Leveraged and Inverse ETFs (L&I ETFs). They do not have implied volatility or higher risk as compared to most other derivative financial products.

How are L&I ETFs different?

While ETFs are core traditional financial products, L&I ETFs operate similar to derivative financial products. Unlike traditional financial products, derivative financial products are complex and highly volatile. Derivatives are often used by traders to express their daily market view or as a hedging tool for their portfolios. Thus, they are used only for active trading.

Investors should always prioritise building up their core investment portfolio first with traditional financial products. Having taken care of that priority, investors can then construct their non-core investment portfolio by using derivatives financial products and L&I ETFs for their personal investment needs.

Should I invest in L&I ETFs?

L&I ETFs are designed for short-term trading needs and are not intended for buy-and-hold purposes. They are very volatile and are appropriate for sophisticated tactical traders who have market views that they want to express. It is of utmost importance that investors monitor and manage their trades daily if they intend to use L&I ETFs as part of their trading strategy.

Now that we know what roles leveraged and inverse ETFs play in your portfolio, let’s take a deeper dive into what exactly these two products do.

What is a leveraged ETF?

Leveraged ETFs are ETFs that participate in a more than proportional manner in the performance of their indices. For example, a 1% increase in the performance of an index can result in an approximate 2% or 3% increase in returns for a 2x or 3x leveraged ETF respectively. On the other hand, a downturn in an index’s performance will result in an amplified decline in the returns of the leveraged ETFs.

They are suitable for investors who have a high conviction in a particular market sector and intend to earn a higher return through leveraged ETFs.

What is an inverse ETF?

Inverse ETFs track the movement of their indices’ performances in the opposite direction. They are designed to have a negative relationship with their benchmark indices. Hence, inverse ETFs are suitable for investors who have a bearish view of a market sector and intend to profit from such a scenario.

There are also Inverse-Leveraged ETFs available for investors who intend to earn a higher return in a bearish market.

How do leveraged and inverse ETFs work?

L&I ETFs use swaps agreements, futures and forward contracts to replicate on a daily basis two or three times the direct or inverse return of their benchmark indices. Before we go further into L&I ETFs, we must acknowledge that they are not designed for investors to buy-and-hold for the long term. They are meant for active trading purposes.

For example, over a one-day period, there may be an inverse relationship between the inverse ETF and the index, but over more extended periods, the relationship may not be applicable.

Investors should also not expect an exact percentage performance return on their L&I ETFs in relation to the performance of the respective indices. A 2x leveraged ETF will not give an exact 2% increase in return should the index performance increase by 1%.

The need to rebalance daily, coupled with the compounding effect will lead to deviation from investment objectives over time but the day-to-day performance of the ETFs should adhere to the investment objectives of the ETFs.

What are the compounding effects of L&I ETFs?

There are various reasons for the deviation from investment objectives. The daily fluctuation of the index will have a more significant influence on the performance of L&I ETFs than they will have on a normal index-tracking ETF. One of the main reasons for this is because of the compounding effect on the performance of the L&I ETFs.

For example, I invested $100 into a 2x leveraged ETF for 2 days. On the first day, the underlying index went up by 10%. So, my 2x leveraged ETF will increase by 20%.

20% X $100 (Investment Amount) = $20 (Gain)

The ETF will produce a 20% return and provide a gain of $20. The new asset value is $100 (Investment Amount) + $20 (Gain) = $120.

If on the second day, the index goes up by 10%, the 2x leveraged ETF will increase by 20% again.

20% X $120 (New Net Asset Value) = $24 (Gain)

So, my ETF will produce a 20% return and provide a gain of $24 on day 2. The compounding effect of the 2x leveraged ETF will return $44 ($20 + $24 = $44) instead of $21. (A normal index tracking ETF will have a value of $121 on Day 2 and a net gain of $21).

But if on the second day, the index goes down by 10%, the 2x leveraged ETF will decrease by 20%.

-20% X $120 (New Net Asset Value) = -$24 (Loss)

The ETF will see a loss of 20% and I will suffer a loss of $24 on day 2. Due to the compounding effect of the 2x leveraged ETF, I suffer a net loss of $4 ($20 – $24 = -$4) even though the market is flat after two days.

A normal index tracking ETF will have a value of $99 on Day 2 and a net loss of $1.

Daily Rebalancing

The L&I ETF will also undergo daily rebalancing to adjust its exposure to the benchmark index. Example:

Day 0:

An Investor bought $100 worth of 2x leveraged ETF. The fund manager will borrow another $100 (via swaps, forwards, futures etc.) to bring investor overall exposure to $200 in order to deliver the 200% return for the next trading day.

Day 1: Index increase by 10%

$200 X 10% = $20

$200 + $20 = $220 (New Exposure)

The exposure will increase to $220 when index increased by 10%.

$220 (New Exposure) – $100 (Borrowed Amount) = $120 (Investor’s Net Asset)

The Investor will be entitled to $120 of the $220 because $100 is borrowed. Hence, the investor will enjoy a 20% return even though the index only increases by 10%.

The investor can exit his trading position with $120, or he can continue to hold his existing position. If he holds his position, the fund manager will have to borrow another $20 to bring the overall exposure to $240 in order to deliver the 200% return for the next trading day.

Day 2: Index decrease by 10%

$240 X -10% = -$24

$240 – $24 = $216 (New Exposure)

The exposure will decrease to $216 when index decreased by 10%.

$216 (New Exposure) – $120 (Borrowed Amount) = $96 (Investor’s Net Asset)

The Investor will only be entitled to $96 of the $216 because $120 is borrowed.

The investor can exit his trading position with $96 or he can continue to hold his existing position. If he holds his position, the fund manager will have to reduce the exposure by $24 to bring the new exposure to $192 in order to deliver the 200% return to the investor for the next trading day.

How can I utilize inverse and leveraged ETFs?

1. Outright Trade

An investor with high conviction about a particular market sector or theme can buy into leveraged ETFs that track the respective market index. Leveraged ETFs can earn a higher return than their traditional index-tracking ETFs counterparts.

Investors who are bearish about a market sector can buy into inverse ETFs instead of borrowing securities to short sell. Thus, they will not be susceptible to force buy-in and the relevant costs that will be incurred during the short-selling process.

2. Hedging

Inverse ETFs can be used as hedging tools to protect against losses in an investor’s portfolio holdings. In the event of a market downturn, the gain from the Inverse ETF is used to offset against the loss in the main portfolio holding. Investors must take note that such a hedging method may not result in a 100% hedge because of tracking errors and other reasons.

It may also not be cost-efficient to sell the main portfolio holdings during periods of downturn, so the availability of inverse ETF allows investors to tide over these periods in the short term.

3. Accelerator

Investors who have a long position in a particular index and wish to accelerate the returns for their portfolio holdings can use leveraged ETFs. This is a more capital efficient method as compared to buying more of the same financial assets for the portfolio.

Which indices have L&I ETFs?

S&P 500

Dow Jones Industrial Average

NASDAQ 100

FTSE China A50

CSI 300 Index

Hang Seng Index

Nikkei 225

TOPIX

Information accurate as at July 2022.