ETF Univ: Leveraged/Inverse ETFs: What You Need To Know

[This article appears in our April 2020 edition of ETF Report.]

ETF UNIVERSITY

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.

These issues have become particularly relevant in the 2020 market meltdown, and have been amplified by the fact that many leveraged and inverse ETFs provide 3x exposure, not just 2x exposure.

Short-Term Products
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.

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% to 100, 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. Twenty% 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%
-2x Naive Return: 2%
-2x Actual Return: -4%

The daily -2x exposure works perfectly, but after two days, the index is down 1%, and the fund is down 4%. Ouch!

Keep An Eye On It
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, which highlights why strong liquidity is so important in these products. Avoid leveraged and inverse funds that trade at wide spreads or low volumes.

SELECTED TERMS

Expense Ratio
The expense ratio is the operating expenses an ETF incurs over a given year divided by its assets. While the expense ratio is not the total cost of ownership an ETF investor faces, it’s the most commonly used metric to assess the cost of an ETF.

Leveraged/Inverse ETFs
Leveraged ETFs offer enhanced returns of a given index over a short period of time. For example, a 2x S&P 500 ETF is designed to deliver twice the daily return of the S&P 500 Index. Most often, the amount of leverage is reset daily, making these vehicles ideal for daily or very-short-term holding periods due to the compounding nature of their returns. They are not long-term, buy-and-hold instruments, but tactical tools for short time horizons. Inverse ETFs work similarly, but they offer the inverse performance of an index.

Net Asset Value
The net asset value (NAV) is a measure of the fair value of an ETF share. It’s the sum of the value of all the securities in an ETF basket, divided by the number of shares of each security in the portfolio. In other words, the NAV tells you how much a share of an ETF is actually worth.

Tracking Difference/Tracking Error
Most ETFs are designed to track an index. Tracking difference, simply put, is the disparity between the returns of an ETF and the performance of the underlying index it tracks. In a perfect world, an index-based ETF would deliver exactly the performance of the index minus its fees (the expense ratio). But other factors can contribute to tracking difference, such as trading and rebalancing costs, as well as tracking methodologies that differ from the original benchmark, among other things. Tracking difference is not to be confused with tracking error, which is a measure of how volatile the performance difference between an ETF and its index is—the standard deviation— on an annualized basis.