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:
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Leveraged and Inverse ETFs and ETNs |
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Leveraged ETFs and ETNsA leveraged ETF or ETN seeks to generate a return that is a multiple (usually 2X or 3X or -2X or -3X) of its benchmark index's performance over a specific, pre-set time period indicated in the funds prospectus. That time period is also referred to as the "rebalancing period", and it is generally only one day, although it could be for a longer time period such as a month. As a result, the returns for these types of ETFs can differ significantly from that of their benchmark index, over periods lasting longer than the rebalancing period because of the compounding of returns. Generally, the longer the security is held, the more likely the returns of the Leveraged product will differ from the long term return of the index. Although 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/ETNsAn 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&P 500'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 a downturn in 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 leveraged short ETFs. Applying the leveraged and inverse concepts described above, these ETFs attempts to amplify the returns of the index they track, but seek two or three times the inverse (negative) return of the underlying index. Correlation Risks and Long-term HoldingA 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 described 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 that index. 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?Let's 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 considering investing in 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 example1: Hypothetical Example 1: How compounding can affect a leveraged ETF/ETNOn 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:
* Assumes the hypothetical ETF has no expenses, achieves its goal of 3X return of index over a one-day time period, and rebalance at the end of each day. Although the percentage decline is the same on Day 2 as the percentage gain on Day 1, the loss is applied to a higher account balance 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 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/ETNsIn addition to the exchange traded features common to all ETFs, leverage and inverse ETFs/ETNs have some features that make them unique. Because these products are generally for short-term timeframes, they are most effective as a trading vehicle, offering:
During a straight trending market (that is, when the market moves in the same direction, up or down, day after day),the effects of compounding allow these ETFs and ETNs to potentially offer increased exposure on the upside and decreased exposure on the down side. Let's look at an example: Hypothetical Example 2: How compounding can affect leveraged and inverse ETF/ETNs in straighttrending markets
Note: For illustration purposes, the example assumes no fees or commissions for the ETFs. It also assumes the hypothetical ETFs perfectly achieve their stated leverage or inverse goals over a one-day time period, and rebalance at the end of each day. In the 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 10% gain is included in the next day's starting account balance. The gains of the leveraged ETFs are even higher, two and three times of the indexs 33.10% return, while the loss is less than the 33.10% for 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/ETNsBecause these products are generally intended for short-term time periods, they are generally most useful as a specialized trading vehicle. They do, however, have many significant risks you should be aware of. Please consult the prospectus for the particular ETF/ETN you are considering to learn more about its risks. Risks of leveraged and inverse ETFs and ETNs include:
Hypothetical Example 3: How compounding3 can affect leveraged and inverse ETF/ETNs in volatile markets
Note: For illustration purposes, the example assumes no fees or commissions for the ETFs. It also assumes the hypothetical ETFs perfectly achieve their stated leverage or inverse goals over a one-day time period, and rebalance at the end of each day. 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 time4. After four days of volatility, the underlying index and the index ETF lost close to 2% solely from compounding. The inverse ETF also lost 2%; a nave 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, experienced larger losses in this example than many investors would anticipant, 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 of these ETFs, coupled with the volatility, results in a negative impact because the ETF amplifies 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.
Please carefully consider the ETF's investment objectives, risks, charges and expenses before investing. For this and other information, call or write to Fidelity for a free prospectus. Read it carefully before you invest or send money. |
Related LinksOn Tuesday, August 18, U.S. securities regulators, SEC and FINRA, posted alerts regarding the unique strategies employed by leveraged and inverse mutual funds and ETFs
Fidelity's ETFThe Fidelity Nasdaq Composite Index Tracking Stock (ONEQ) seeks to mirror the performance of the Nasdaq Composite Index. The Important information on Purchasing a Precious Metals ETP in a Retirement Account. |
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