Leveraged and Inverse ETFs and ETNs

A leveraged ETF/ETN is a special kind of ETF that is designed to return some multiple of its benchmark index's performance over a specific, pre-set time period. That time period most often is daily but can be monthly. The time period over which a leveraged product seeks its return is also referred to as the rebalancing period. For example, a leveraged ETF may seek a return of 2x or 3x an index over the rebalancing period (which is usually a day, but can be a month or some other period). Although the potential returns are increased by leveraging, so are the potential losses, so these securities carry significant risk. As a result, Leveraged and Inverse ETFs are intended only for sophisticated investors with an aggressive tolerance for risk.

Inverse ETFs/ETNs

An inverse ETF or ETN attempts to mimic the inverse, or opposite, of its stated benchmark. For example, an inverse S&P 500 ETF would attempt to deliver the opposite of the S&P500's daily performance, net of fees. These funds, also called "short ETFs or Bear ETFs" are often used by investors in an attempt to profit from downward direction of a given market, sector, or index, or to hedge against a potential loss in their portfolio. Although an inverse, or 1x inverse ETF does not explicitly use leverage to magnify the intended return, they can suffer from the same compounding effects as the leveraged long and leverage short ETFs.

Applying the leveraged and inverse concepts described above, these ETFs attempts to amplify the returns of the index they track, but seek 2x or 3x the inverse (negative) return of the underlying index.

Correlation Risks and Long-term Holding

A number of factors may hinder a leveraged or inverse ETF/ETN's ability to achieve correlation with its benchmark index, including fees, expenses, transaction costs, use of margin or other leveraged investment techniques, index rebalancing, and other factors set forth in the prospectus . The effects of leverage and compounding, however, are the two primary reasons why the return of an index over the specified rebalancing period does not translate into the return of a leveraged or inverse ETF held for longer than the rebalancing period (and remember, a leveraged or inverse ETF does not typically attempt to track an index over any period longer than the rebalancing period, which is most commonly one day).

Compounding and leverage are likely to have a significant effect on long-term performance, whether positive or negative. This is one reason why a leveraged or inverse ETF/ETN that closely tracks the daily performance of an index will not necessarily track the long-term performance of an index if it is held over time. When held for longer than one day, a leveraged or inverse ETF/ETN that seeks to achieve a multiple of the daily return of a benchmark index can even have negative performance over a period in which the benchmark index achieved positive returns. This divergence tends to be particularly pronounced in volatile markets, but can also occur in relatively "flat" markets.

How do they work?

Lets illustrate how a leveraged ETF might function: A 3x ETF has a daily rebalancing period in which it seeks to return three times (300%) the return of a particular index each day. To achieve that one-day goal, the 3x ETF rebalances its holdings daily. The 3x ETF does not seek to return 3x the index's return over any period longer than one day.

As part of its daily return objective, the issue of compounding is a factor you must understand when discussing leverage and inverse products. Due to the magnification of compound returns of the index, the Leveraged Product does not correlate with the return of the index when held for longer than the rebalancing period, here's an example of this:

On Day 1, the XYZ index increases in value from $100 to $105, a gain of 5%. On Day 2, the XYZ index declines 5%, from $105 to $99.75, In the aggregate, the XYZ index has moved slightly below its original value. An investment in a fund that perfectly replicated the index would be expected to gain 5% on Day 1 and lose 5.00% on Day 2 and reflect the value of the index - 99.75, as shown in the table below.

By contrast, an investment in a 3X leveraged fund will gain 15% on Day 1 and lose 15% on Day 2, resulting in a larger loss than the index, as shown in the table below:

Although the percentage decline is the same on Day 2 as the percentage gain on Day 1, the loss is applied to a higher principal amount so the investment in the 3X leveraged fund has a larger loss than the index over the same two day period.

Because of rebalancing, compounding and other risks we will discuss in the "Risks" section below, Leveraged and Inverse ETFs are intended to be used as short-term trading vehicles for sophisticated investors actively monitoring their portfolios on a daily basis.

What are some of the features of Leveraged and Inverse ETFs/ETNs

In addition to the Exchange Traded features listed above for all ETFs, Leverage and Inverse ETFs/ETNs have some features that make them unique.

Because these products are generally for short-term time frames, they are most effective as a trading vehicle. They do offer:

In a Straight Trending Market shown above, if the benchmark index is up 10% for three days in a row, the return of the fund will not be 30% (10% + 10% + 10%). Rather, due to compounding, the actual return is 33.10% because each prior day's gain of 10% is included in the next day's starting price. This translates to the Leveraged Securities in a positive way as gains are higher than the 2x or 3x of 33.10%, while the loss is less than the 33.10% in the 1x Inverse ETF.

Remember, this is based on a straight trend (day after day of the market moving in the same direction); we will discuss what volatility means to these products in the "Risks" section.

What are some of the risks associated with Leveraged and Inverse ETFs/ETNs

Because these products are generally for short-term time frames, they are generally useful as a specialized trading vehicle. They do however have many significant risks that you should be aware of. Please consult the prospectus for the particular ETF/ETN you are considering to learn more about the risks.

In this example, the index moves alternately up and down 10% over each of four days. As the chart shows, on any one day the movement of the ETFs is a simple multiple of 100%, 200% or 300% of the Indexes' performance. Over time, compounding begins to affect the return of the index and the ETFs. The effect may be greater the longer the security is held and the higher the leverage.

The chart above illustrates that compounding can significantly affect both the index and ETFs over time¹. After four days of volatility, the underlying index, the Index ETF lost close to 2% solely from compounding. The Inverse ETF also lost 2%, a naïve investor may have expected a positive 2% return over this time in the inverse ETF, but that is not the case. The 2x and 3x leveraged ETFs, experience a larger than anticipated lose in this example losing -7.87% and -17.19%, respectively.

In essence, the fund follows a momentum strategy which responds to gains by increasing exposure and responds to losses by decreasing exposure. This is not helpful in a market which lacks direction. A gain leads to increased exposure in advance of a loss, which then leads to decreased exposure in advance of a gain, and so on. The rebalancing requirement, coupled with the volatility results in a negative impact because the ETF is amplifying the movement of the index and the increased daily exposure results in more violent price swings.

In general, periods of high index volatility will cause the effect of compounding to be more pronounced, while lower index volatility will produce a more muted compounding effect. However, compounding is likely to have a significant effect on long-term performance, whether positive or negative². This is the main reason why a Leveraged or Inverse Security does not track the long-term performance of an index if it is held over time.

When held for longer than one day, a Leveraged or Inverse Security that seeks to achieve a multiple of the daily return of an underlying index can even have negative performance over a period in which the underlying index achieved positive returns. The path that the index took during any particular period is as important as the start and end points. This divergence tends to be particularly pronounced in volatile markets, but can also occur in less volatile markets.