Leveraged and Inverse ETFs 101 June 8, 2018

Introduction

Exchange-Traded Funds (ETFs) are open-ended investment funds listed and traded on stock exchanges. They aim to track, replicate or correspond to the performance of an underlying index or assets. 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).

Leveraged ETF

Figure 1: Leveraged ETFs vs Underlying Benchmark Index

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 are intending to earn a higher return through leveraged ETFs.

Inverse ETF

Figure 2: Inverse ETFs vs Underlying Benchmark Index

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 are having a bearish view on a market sector and are intending to profit from such a scenario.

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

Features of Leveraged and Inverse ETF

  1. Trade on exchanges like stocks with full price transparency
  2. Up to 3x (2x and 3x leveraged ETFs) or -3x (-1x, -2x and -3x inverse ETFs) participation in the performance of an index
  3. Maximum loss for investors is the initial capital invested
  4. Do not have implied volatility or knock out risk as compared to most derivative instruments



Traditional Financial Products vs Derivatives Financial Products

L&I ETFs operate similarly to derivatives financial products. Unlike traditional financial products, derivatives financial products are complex and highly volatile. Derivatives financial products are often used by traders to express their daily market view or as a hedging tool for their portfolios.

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 utilising derivatives financial products and L&I ETFs for their personal investment needs.

Figure 3: Core and Non-Core Part of Investment Portfolio


Characteristics of Traditional and Derivatives Financial Products

Traditional Financial Products Derivatives Financial Products
Long-term and/or short-term Take advantage of market trends tactically
Buy-and-hold and/or active trading Daily monitoring is required
Suitable for passive and/or active investment Liquidity is critical for daily trading
Generally less volatile Adjust portfolio’s market exposure, risk and return profile

Now that we are familiar with the basics of L&I ETFs, we shall discuss the composition and mechanics of L&I ETFs in the next section of the article.

Leveraged and Inverse ETFs’ Composition and Mechanics

L&I ETFs use swaps agreements, futures and forwards contracts to replicate on a daily basis two or three times the direct or inverse return of their benchmark indices. Before we dwell further into L&I ETFs, we must acknowledge the fact 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.

Compounding Effects of Leveraged and Inverse 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 is because of the compounding effect on the performance of the L&I ETFs.

Example:

Scenario 1: I invested $100 into a 2x leveraged ETF for 2 days

Day 1: Index went up by 10%, 2x leveraged ETF will increase by 20%:

20% X $100 (Investment Amount) = $20 (Gain)
My ETF will produce a 20% return and provide a gain of $20
$100 (Investment Amount) + $20 (Gain) = $120 (New Net Asset Value)

Day 2: Index went up by 10%, 2x leveraged ETF will increase by 20%:

20% X $120 (New Net Asset Value) = $24 (Gain)
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. (Normal index tracking ETF will have a value of $121 on Day 2 and a net gain of $21).


Scenario 2: I invested $100 into a 2x leveraged ETF for 2 days

Day 1: Index went up by 10%, 2x leveraged ETF will increase by 20%:

20% X $100 (Investment Amount) = $20 (Gain)
My ETF will produce a 20% return and provide a gain of $20.
$100 (Investment Amount) + $20 (Gain) = $120 (New Net Asset Value)

Day 2: Index went down by 10%, 2x leveraged ETF will decrease by 20%:

-20% X $120 (New Net Asset Value) = -$24 (Loss)
My ETF will experience a loss of 20% and I suffered a loss of $24 on Day 2.
Because of the compounding effect of the 2x leveraged ETF, I suffered a net loss of $4 ($20 – $24 = -$4) even though the market is flat after two days. (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:

Figure 4: Illustration of L&I ETFs Daily Rebalancing

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.

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 performances will deviate from their investment objectives.

In summary, 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.

After getting the basics and mechanics of L&I ETFs down, we can now discuss how investors can use L&I ETFs to execute their trading strategies.

Three Ways to Utilise Inverse and Leveraged ETFs

1. Outright Trade

Investors with a specific market outlook can trade on L&I ETFs.

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.

Figure 5: Outright Trading Strategies

2. Hedging

Inverse ETFs can be used as hedging tools to protect against losses for 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 error and other various reasons.

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

Figure 6: Hedging with Inverse ETFs

3. Accelerator

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

Figure 7: Using Leveraged ETF as an Accelerator

Investors’ Suitability for 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.

Suitable for investors who Not suitable for investors who
Are risk takers and can accept losses on their investment Are conservative and want their initial investment capital to be protected
Understand the unique nature and performance characteristics of the ETFs Are unfamiliar with the unique nature and performance characteristics of the ETF
Active traders who are constantly monitoring the market so that they are able to give timely respond to changing market conditions Passive investors who do not monitor their portfolio daily

Conclusion

With the market and environmental conditions constantly changing, there are ample catalysts for higher upside gain and downside volatility. Investors planning to gain access to global trading trends can employ various trading techniques and strategies with L&I ETFs to achieve their short-term investment objectives.

Specified Investment Products

L&I ETFs are classified as Specified Investment Products (SIP) because of their complex nature. Investors are required to clear their Customer Account Review (CAR) before they are allowed to trade L&I ETFs.

Investors should also consult their qualified financial advisors or investment professionals should they encounter any queries about L&I ETFs before trading on such instruments.

Examples of Leveraged and Inverse ETFs in the Market

S&P 500

ETF Name Exchange Ticker Code Leveraged/Inverse Leveraged Amount
ProShares Ultra S&P 500 AMEX SSO Leveraged 2x
ProShares UltraPro S&P 500 AMEX UPRO Leveraged 3x
Direxion Daily S&P 500 Bull 2x Shares AMEX SPUU Leveraged 2x
Direxion Daily S&P 500 Bull 3x Shares AMEX SPXL Leveraged 3x
ProShares Short S&P 500 AMEX SH Inverse -1x
ProShares UltraShort S&P 500 AMEX SDS Inverse -2x
ProShares UltraPro Short S&P 500 AMEX SPXU Inverse -3x
Direxion Daily S&P 500 Bear 1x Shares AMEX SPDN Inverse -1x
Direxion Daily S&P 500 Bear 3x Shares AMEX SPXS Inverse -3x

Dow Jones Industrial Average

ETF Name Exchange Ticker Code Leveraged/Inverse Leveraged Amount
ProShares Ultra Dow 30 AMEX DDM Leveraged 2x
ProShares UltraPro Dow 30 AMEX UDOW Leveraged 3x
ProShares Short Dow 30 AMEX DOG Inverse -1x
ProShares UltraShort Dow 30 AMEX DXD Inverse -2x
ProShares UltraPro Short Dow 30 AMEX SDOW Inverse -3x

NASDAQ 100

ETF Name Exchange Ticker Code Leveraged/Inverse Leveraged Amount
ProShares Ultra QQQ AMEX QLD Leveraged 2x
ProShares UltraPro QQQ NASDAQ TQQQ Leveraged 3x
ProShares Short QQQ AMEX PSQ Inverse -1x
ProShares UltraShort QQQ AMEX QID Inverse -2x
ProShares UltraPro Short QQQ NASDAQ SQQQ Inverse -3x

FTSE China A50

ETF Name Exchange Ticker Code Leveraged/Inverse Leveraged Amount
ProShares Ultra FTSE China 50 AMEX XPP Leveraged 2x
Direxion Daily FTSE China Bull 3x Shares AMEX YINN Leveraged 3x
ProShares Short FTSE China 50 AMEX YXI Inverse -1x
ProShares UltraShort FTSE China 50 AMEX FXP Inverse -2x
Direxion Daily FTSE China Bear 3x Shares AMEX YANG Inverse -3x

CSI 300 Index

ETF Name Exchange Ticker Code Leveraged/Inverse Leveraged Amount
Direxion Daily CSI 300 China A Share Bull 2x Shares AMEX CHAU Leveraged 2x
Direxion Daily CSI 300 China A Share Bear 1x Shares AMEX CHAD Inverse -1x

Hang Seng Index

ETF Name Exchange Ticker Code Leveraged/Inverse Leveraged Amount
CSOP HSI Daily 2x HKEx 7200 Leveraged 2x
ChinaAMC Direxion HSI Daily 2x HKEx 7221 Leveraged 2x
Mirae Asset Horizons HSI Daily 2x HKEx 7231 Leveraged 2x
CSOP HSI Daily -1x HKEx 7300 Inverse -1x
ChinaAMC Direxion HSI Daily -1x HKEx 7321 Inverse -1x
Mirae Asset Horizons HSI Daily – 1x HKEx 7336 Inverse -1x

Nikkei 225

ETF Name Exchange Ticker Code Leveraged/Inverse Leveraged Amount
Daiwa ETF Japan Nikkei 225 Leveraged Index TSE 1365 Leveraged 2x
Listed Index Fund Nikkei Leveraged Index TSE 1358 Leveraged 2x
NEXT FUNDS Nikkei 225 Leveraged Index ETF TSE 1570 Leveraged 2x
Daiwa ETF Japan Nikkei 225 Inverse Index TSE 1456 Inverse -1x
Daiwa ETF Japan Nikkei 225 Double Inverse Index TSE 1366 Inverse -2x
NEXT FUNDS Nikkei 225 Inverse Index ETF TSE 1571 Inverse -1x
NEXT FUNDS Nikkei 225 Double Inverse Index ETF TSE 1357 Inverse -2x

TOPIX

ETF Name Exchange Ticker Code Leveraged/Inverse Leveraged Amount
Daiwa ETF Japan TOPIX Leveraged Index TSE 1367 Leveraged 2x
TOPIX Bull 2x ETF TSE 1568 Leveraged 2x
Daiwa ETF Japan TOPIX Inverse Index TSE 1457 Inverse -1x
Daiwa ETF Japan TOPIX Double Inverse Index TSE 1368 Inverse -2x
TOPIX Bear -1x ETF TSE 1569 Inverse -1x
TOPIX Bear -2x ETF TSE 1356 Inverse -2x

ETFs Information are accurate as of 28 December 2018.

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About the author

Mr. Joel Lim
ETF Specialist

Joel graduated from Singapore Institute of Management, University of London with a First Class Honours in Business. He was the recipient of SIM University of London’s Top Student Bronze Award in 2017 and was the worldwide examination topper for the “Financial Management” module in 2016. Joel was also commended by University of London for his excellent performance in the 2014 Examinations.

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