What You Should Know About Leveraged and Inverse ETFs
What are leveraged and inverse ETFs?
ETFs that seek to produce a return that is a multiple of the return of its benchmarked index are commonly known as “leveraged”. There are currently more than 100 different funds in this category with benchmarks that track commodities, currencies and various stock indexes. Some leveraged ETFs have multipliers of double or triple the benchmark (i.e., 2x or 3x), while others target returns that are based on the inverse of the benchmark (i.e., -1x, -2x or -3x). It is critical to understand the time period for which the leverage applies. Each fund explicitly states this time period in its prospectus.
At the time of this writing, all leveraged and inverse ETFs are designed to generate daily returns that are a positive or negative multiple of the daily return of a specified index. They are not designed to match the return for a holding period that is longer than the objective stated in the prospectus. Therefore, the daily compounded return of a leveraged ETF over one year, one month, one week, or even a two-day period may be significantly different from the returns produced by simply applying the stated multiple to the index’s total holding period return. Daily monitoring and adjustment (buying and selling) by the investor could modify the return to match its stated objective over time.
Daily leveraged ETFs may be unsuitable for investors who seek an intermediate-term or long-term holding period. Instead, this type of leveraged ETF may be better suited to traders who wish to increase or hedge their market exposure over a short period of time. Investors are encouraged to consult with their financial advisors or registered representatives to help determine if leveraged or inverse ETFs are suitable for them.
What are the additional concerns an investor should review before investing in a leveraged or inverse ETF?
Inverse ETF fund managers may, at times, be unable to fully carry out their short-selling strategy as a result of difficulties in the derivatives markets, regulatory restrictions, or their inability to locate and borrow shares or for other reasons. This could cause the market price of the ETF to vary from its index target and NAV.
Many leveraged ETFs (of both the long and the short varieties) rely on the use of futures, swaps and other derivative securities, along with other securities or commodities, to achieve their target returns. Some of these derivatives, such as swaps, are unlisted securities that depend on the swap issuer’s ability to pay. Therefore, the leveraged ETFs that depend on such swaps may not be able to achieve their stated returns if a swap counterparty should default.
Leveraged and inverse ETFs may be less tax efficient than other ETFs. It is possible for investors to have a tax liability, even in a year in which the leveraged or inverse ETF had a negative overall return. This outcome can result from the fund managers “rebalancing” the investments each day with derivatives to maintain the ETF’s multiple. Such rebalancing can produce realized taxable gains with no offsetting losses. As with any potential investment, an investor should consult with his or her tax advisor and carefully read the prospectus to understand the tax consequences of leveraged or inverse ETFs.