Leveraged and inverse ETFs are powerful tools that allow investors to magnify the returns on an investment. While higher returns always sound better, leveraged and inverse ETFs are highly specialized tactical tools that should be implemented with caution. These products are primarily intended for professional traders. Advisors and individuals can use inverse funds as hedging tools, but they must know how the products really work and must rebalance their positions.
Leveraged or inverse ETFs deliver the desired returns over prespecified periods only—usually one day. By “desired returns,” we mean the stated multiple (2x or -1x, for example) of the fund's underlying index; that is, an ETF that offers 2x exposure to the S&P 500 only attempts to do so over one-day holding periods. Investors can hold the ETF for longer than a day, but returns can vary significantly from 2x exposure over longer periods. That’s because the ETF resets its leverage daily. In oscillating markets, the leverage reset can significantly erode returns. A lot.
The math of resetting can be confusing, but the concept is one that’s well known: compounding. Every day, the fund earns a return, either positive or negative, and it must reset its exposure to maintain a constant multiple to a changing asset base.
Here’s a hypothetical example:
On day 1, the -2x fund is at 100. On day 2, the index goes up 10 percent to 110, and the fund falls 20 percent to 80. So far, so good. But on day 3, the index falls 10 percent: 10 percent of 110 is 11, so the index falls from 110 to 99. Twenty percent of 80 is 16, so the fund rises from 80 to 96.
This example shows the fund doing exactly what it promises—delivering -2x returns each day. The example also shows how an investor can get burned:
Index return: -1 percent
-2x Naive Return: 2 percent
-2x Actual Return: -4 percent
The daily -2X exposure works perfectly, but after two days, the index is down 1 percent, and the fund is down 4%. Ouch!
To be clear, if you’re making a short-term bet on something—speculating, in other words—you may not care about achieving the precise multiple.
However, if you’re trying to hedge interest-rate risk or currency exposure in a portfolio context, you simply must monitor and rebalance your exposure for anything but the shortest time frame. Techniques for rebalancing include time-based and trigger-based. A time-based approach is simply a calendar method in which you check your position every X number of days to compare its value against either the underlying index or whatever you’re trying to hedge in your portfolio. A trigger is a threshold, which could be dollars or volatility.
In general, a more volatile underlying asset and or a higher multiple means more rebalancing.
Rebalancing means buying or selling the inverse ETF to realign to the desired multiple—trading, in other words—which highlights why strong liquidity is so important in these products. Avoid levered and inverse funds that trade at wide spreads or low volumes.
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