[This article appears in our February 2021 issue of ETF Report.]
If you take a deep breath before diving into this article, you’re not alone. Leveraged and inverse ETFs have a long-standing reputation of being overly complicated, delivering return streams that can result in confounded investors.
These products are index-based trading tools, and they’re all about the math. The compounding of returns tied to the level of leverage of each of these strategies can quickly grow in magnitude in either direction—super booster or super bummer. Sure, that massive run to the upside is thrilling, but equally large or even larger losses dot the space like headstones in a graveyard.
Yet this part of the ETF universe has a long, rich history dating back to the first launch by ProShares in 2006. Currently, leveraged and inverse ETFs listed in the U.S. have more than $57 billion in assets under management. There are 88 inverse ETFs and 106 leveraged ETFs.
In 2020, the inverse and leveraged space experienced a paradigm shift, as a large number of leveraged and inverse funds listed in the U.S. shuttered, many of them reduced to ashes by the market volatility seen during the year.
New launches, meanwhile, were few. The leveraged funds had a net loss of 56 products, while the inverse ETF universe fell by more than 30 products. What happened?
First, let’s be clear: Leveraged and inverse ETFs do—and have done—exactly what they’re designed to. There have never been any accusations that these funds don’t produce results aligned with their stated goals.
But go back to March 2020 and the volatile market action we saw then and won’t soon forget. Massive price dislocation at amazing volume and speed was the perfect storm to rattle ETFs seeking to deliver geared returns. Many geared strategies saw share prices drop dramatically, forcing some ETNs into mandatory redemptions. Closures quickly mounted.
Yet as some crashed and burned, others soared, with popular products like the MicroSectors FANG+ Index 3X Leveraged ETN (FNGU) and the ProShares UltraPro QQQ (TQQQ) up 379% and 110% for the year, respectively.
Lois Gregson, senior ETF analyst with FactSet, says this pruning of the space is a good thing.
“Issuers want investors to have a good experience, and to work with clients who understand their products. They want them to be used in the way they’re intended to be used,” she said. “It’s easy to misunderstand these products, so I think they’re taking a close look at how they can best serve the investment community.”
For a larger view, please click on the image above.
Of these geared ETFs, 36 offer 3x exposure to an underlying index, while 62 offer 2x exposure. Another 23 provide -3x exposure, while 39 have -2x exposure and 22 provide -1x exposure. There are a handful of funds that offer variable or other multiples, but no existing products currently provide exposure in magnitudes greater than 3x/-3x.
Given that the entire U.S.-listed ETF and ETN universe at the end of 2020 was just shy of 2,400 products, and assets under management are approaching $5.7 trillion, leveraged and inverse products are a drop in the bucket. Their alchemy, however, is fairly potent.
Leveraged and inverse ETFs were controversial right out of the gate in 2006. Even though 2x leveraged and inverse exposure had been around for several years by that time in a mutual fund wrapper, regulators were uneasy with the risks associated with these products. The SEC sat on the original ProShares filing for the first-of-their-kind ETFs for over seven years before approving it.
Over the years, the SEC has alternated between approving applications for geared investment vehicles and raising concerns about them. Regulators have had a troubled relationship with these strategies.
The primary concern about using leveraged/inverse ETFs is that investors don’t understand how they work, and therefore can get burned due to the increased risk that comes with an amped-up ride and math that isn’t apparent on the surface. You don’t get 2x or 3x that the performance of the underlying index no matter the time period you hold it; it’s more complicated than that.
After all, if a fund can go up twice its index in one day, it can go down just as much. And that’s putting it simply, because things like compounding, erosion and daily resets—largely foreign concepts to many ETF investors at the time of their first debut—can turn the ride wild very quickly.
As the years went on, this segment of ETFs grew, and the 2x, -2x and -1x funds were joined by 3x and -3x ETFs. The concerns never really went away—regulators continue to focus on the need for investor education; on the swaps underlying the funds and their transparency (or lack thereof); and the market impact of the products—namely, did they add to market volatility?
The SEC even put a freeze, or a timeout, on applications from new issuers to launch leveraged and inverse ETFs back in 2010, essentially giving Direxion and ProShares—the only two issuers with these types of products in the market at the time—a duopoly on the space.
There have been warnings about and investigations into these products almost from the moment the first ones launched. There have been lawsuits against their issuers as well. But to no avail, because at the end of the day, these powerful tools have been delivering on their design. The confusion from investors using these trading tools as buy-and-hold products is more often than not the root of investor discontent.
A few years ago, we almost saw 4x ETFs make it to market, showing that attitudes can change over time. Consider also that when the SEC talked about imposing further limits on how retail investors could access leveraged and inverse ETFs in 2019, it received about 6,000 letters on the matter speaking out against such changes.
Changes To The Rules
Ultimately, Rule 18f-4 under the Investment Company Act, approved in late 2020, has done much to clarify many of the concerns and uncertainties around leveraged and inverse ETFs.
For one thing, it opened up the market for new products again, so that issuers don’t need special exemptive relief to launch such funds, meaning other issuers besides Direxion and ProShares can easily enter the space.
The rule also limited the amount of leverage that could be offered to 200% (in either direction). The existing funds offering 3x exposures can continue to trade, but no one can issue any more of them. We may have gotten increasingly more comfortable with playing with fire, but regulators are holding steady on their mission to protect us from getting burned.
To Direxion President Rob Nestor, new players in this space would be a welcome addition. He says his firm has always been uncomfortable, on principle, with the effective duopoly they’ve had with ProShares on leveraged and inverse products. Although firms like MicroSectors, Velocity-Shares and UBS offer leveraged and inverse exchange-traded notes, ProShares and Direxion are the only firms that do so with the ETF wrapper.
“We’ve encouraged rule making that would open it up to other providers,” Nestor said. “Competition is a bedrock of our system.”
The changes “will also open the door to greater competition, choice and innovation, which we welcome, as it’s fundamentally a good thing for investors,” said ProShares CEO Michael Sapir, though he does not believe the decision to disallow more 3x/-3x ETFs was in investors’ best interests.
ETNs Part Of The Formula
Remember that exchange-traded notes are an entirely different structure that’s not governed by the 1940 Act, and there are quite a few inverse and leveraged products in their ranks. They’re often lumped in with ETFs, but at their most basic level, they’re unsecured debt obligations that don’t actually hold anything.
The lack of regulation around ETNs has made them a popular wrapper for leveraged and inverse exposure, but the ETN structure can be fickle. In 2016, Credit Suisse closed two of its most successful and popular ETNs, the VelocityShares 3x Long Crude Oil ETN (UWTI) and the VelocityShares 3x Inverse Crude Oil ETN (DWTI), which were approaching combined assets under management of $2 billion.
At the time, it was assumed that Credit Suisse wanted to clean up its balance sheet, and the extra $1 billion in debt didn’t look good. Whatever their motivation, that move was a reminder that most ETN prospectuses (at least the newer ones) clearly state that they’re subject to being called by their issuers at will. And if they delist—relegating them to over-the-counter (OTC) markets—they can leave investors trapped due to the illiquid nature of OTC trading. That doesn’t happen often, but it could.
Ultimately, geared ETNs are a miniscule portion of the overall exchange-traded product universe, representing about 30 products (22 leveraged, nine inverse), only one of which, FNGU, has more than $1.25 billion in assets under management. The entire group of leveraged and inverse ETNs has about $2.6 billion in assets.
Leveraged and inverse ETFs may not be for everyone, but their history and performance over the years continue to show two important things. First, when used properly, these types of strategies can deliver outsized performance—or desired hedging—as designed. More importantly, they show that the ETF wrapper can deliver access to even some of the most complicated strategies, even if that math can leave many dazed during volatile times.
Complicated or not, there’s a lot to like about getting twice the returns of an index, which is what a 2x leveraged ETF promises. It’s just important to keep in mind some best practices ideas when using these funds.
The first thing to remember is that these products have resets. A few ETNs have monthly resets, which means that if the index goes up 5% in a month, your portfolio goes up 10%. However, the majority of leveraged and inverse ETFs have a daily reset. That means that, every day, the 2x multiplier restarts. It also means the math doesn’t work quite the way most people think if they just took a cursory look at the chart.
For example, if your 2x fund’s index goes up 1% on a particular day, you get a return of 2% that day. However, if you buy a 2x leveraged ETF and its index goes down 1% on that day, and then on the next day it goes back up 1%, you’re still not back to where you started, because that 1% of upside builds off the lower starting point on that second day.
The table to the left provides a more in-depth explanation involving a -2x fund.
On day 1, the -2x fund is at 100. On day 2, the index goes up 10% to 110, and the fund falls 20% to 80. So far, so good. But on day 3, the index falls 10%: 10% of 110 is 11, so the index falls from 110 to 99. And 20% 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 compounding can add up quickly and surprise an investor.
After all, the daily -2x exposure works perfectly, but after two days, the index is down 1%, and the fund is down 4%. These effects are amplified even further when you look at the 3x and -3x ETFs.
This product design, while effective when used correctly, is the reason most investors don’t look at leveraged and inverse ETFs as long-term holdings. The daily reset feature makes these products ideal for very-short-term holding periods—as in one day, or perhaps one week—so turnover in these ETFs is pretty big.