A Guide to Leveraged and Inverse ETFs
Investors should understand the math behind leveraged and inverse ETFs before buying them.
There is more money invested in leveraged and inverse ETFs than investors may know. As of the end of July 2023, U.S.-listed leveraged and inverse ETFs had assets under management of $94 billion.
That’s almost 12 figures invested in a corner of the ETF market that isn’t well understood by many investors. Leveraged and inverse ETFs are prolific. Out of the nearly 3,200 U.S.-listed ETFs out there right now, about one out of every dozen is a leveraged or inverse product.
They're extremely popular too. Products like the ProShares UltraPro QQQ (TQQQ), the Direxion Daily Semiconductor Bull 3X Shares (SOXL) and others have billions of dollars in assets.
Yet despite their popularity, the leveraged and inverse ETF space is surrounded by controversy. Many believe these products should be outright banned due to their volatile nature. Some even consider them tools for gamblers, as they point to the tremendous losses that some of these products have seen.
Leveraged and Inverse ETFs
The unsavory reputation that leveraged and inverse ETFs have received isn't completely unwarranted. The $460 million Direxion Daily Gold Miners Index Bull 2X Shares (NUGT) and the $1 billion ProShares Ultra Bloomberg Natural Gas (BOIL) are both down more than 99.9% since inception―a breathtakingly horrible return by any measure.
But that doesn't mean they haven't done exactly what they were designed to do, which is provide 2x daily leveraged exposure to the indexes they track. For NUGT, that means 2x exposure to a basket of gold miner equities, and for BOIL, it means 2x exposure to natural gas futures contracts.
They key word is “daily”―these products only promise to deliver 2x the return of their underlying index over a one-day period. Over longer-term periods, the pattern of returns between the index and the products can deviate significantly because of daily rebalancing.
Daily Rebalancing Leveraged and Inverse ETFs
To illustrate this effect, consider a hypothetical example where oil is trading at $100/barrel and the ProShares Ultra Bloomberg Crude Oil (UCO), a 2x leveraged oil futures ETF, is trading at $20.
If oil rises by 10% to $110 on the next day, UCO will increase by 2x that amount, or 20%, to $24.
However, if oil declines to where it began at $100 on the following day―a loss of 9.1%―UCO will drop 18.2% to $19.63. That translates to a two-day loss of 1.9% for UCO even though oil is simply back to where it started.
For ETFs tied to volatile flat-to-down-trending areas of the market—such as oil and other commodities—this rebalancing effect has a detrimental effect on returns over time.
For very-short-term traders, that's not a concern. They can use these ETFs to trade in and out of the market in an attempt to capture quick gains that will be close to 2x or 3x the index. It's the longer-term holders of these ETFs—who often don't know how these products work—who end up disappointed or devastated.
Does that mean these funds should be banned? Not necessarily. But investors should thoroughly understand what they’re getting into before purchasing these ETFs.
Positive Compounding of Inverse and Leveraged ETFs
That said, it's not possible to make the blanket statement that all geared products perform poorly over longer time horizons. For areas of the market that are trending higher, the daily rebalancing effect can have a decidedly positive effect on returns.
Consider an index that rises 10% five days in a row from a starting value of 100. On day five, the index will be trading at 161.1, a gain of 61.1%. A triple-leveraged ETF that tracks the index will rise by 30% in each of those five days, ending with a gain of 271.3%.
In this case, the geared product will have delivered almost 4.5x the return of the underlying index―better than the advertised leverage ratio.
Of course, indexes or assets don’t generally go straight up without at least some volatility. But this example shows that certain leveraged products can be viable to hold over longer-term periods.
One product that fits the bill is the Direxion Daily S&P 500 Bull 3X Shares (SPXL), which is up an enormous 2,632% over the past 15 years, compared with a return of 360% for the SPDR S&P 500 ETF Trust (SPY). That's almost 7.3x the return!
Bull Market Timing in Inverse and Leveraged ETFs
Of course, just because SPXL has performed well during the last decade and a half doesn't mean it will do so going forward. In fact, over the past two years, it’s down 20.5% compared with a gain of 4.6% for SPY.
That's because the S&P 500 has been flat and volatile during the past few years, and geared products perform poorly under those conditions—and even worse when markets go down.
Of course, just because SPXL has performed well during the last decade and a half doesn't mean it will do so going forward. In fact, over the past two years, it’s down 20.5% compared with a gain of 4.6% for SPY.
That's because the S&P 500 has been flat and volatile during the past few years, and geared products perform poorly under those conditions—and even worse when markets go down.
SPXL and similar ETFs perform well in up-trending markets with minimal downside volatility, which are typical conditions of a bull market. That makes them great market-timing tools for aggressive investors with time horizons up to several years, but they're by no means buy-and-hold-forever ETFs.
What Are Inverse ETFs?
Like leveraged ETFs, another set of funds that cater to aggressive investors are inverse ETFs. These funds provide the opposite of the daily return of the index or asset they track.
For instance, returns for the $1.7 billion ProShares Short S&P500 (SH) correspond to -1x the daily performance of the S&P 500. When the index rises by 1%, SH falls by 1%, and vice versa.
Inverse ETFs can be unleveraged, like SH, or leveraged, like the $4.5 billion ProShares UltraPro Short QQQ (SQQQ), which offers -3x exposure to the Nasdaq-100.
The math for inverse ETFs works in much the same way it does for leveraged ETFs. Even an unleveraged inverse fund like SH will face volatility-related performance drag over time.
For instance, if the S&P 500 rises from 4,000 to 4,120 (a gain of 3%) one day and then falls back to 4,000 the next day (a loss of 2.9%), SH will fall by 3% on the first day (say, from 100 to 97) and then rise by 2.9% on the next day (from 97 to 99.83).
That 0.17% decline from 100 to 99.83 is the drag from daily rebalancing.
Finding Leveraged and Inverse ETFs
Now that you’re acquainted with the math behind leveraged and inverse ETFs, you’re in a better position to trade or invest in them. They’re certainly not for everybody, but for those with short holding periods or high risk tolerances, these funds might be appealing.
Aside from managing these risky ETFs, the hardest thing for you to do is find the right fund for your purposes. Today, there are around 269 leveraged/inverse ETFs listed in the U.S., so it’s no small task to sort through them all.
Fortunately, ETF.com’s stock screener tool helps make it easy to do so. To find leveraged and inverse ETFs, click the “features” tab on the left-hand side of the screener.
You’ll find leveraged and inverse ETFs tied to many different parts of the financial markets, including broad stock market indexes, sectors, themes, bonds, commodities and even single stocks.
The Largest Leveraged ETFs
10 Largest Inverse ETFs
Most leveraged ETFs target 2x to 3x the daily return of an index or asset. But starting in 2020, rules put in place by the SEC limited the leverage on ETFs to 2x or less (older funds were grandfathered in so they still offer leverage of up to 3x).
Most inverse ETFs are leveraged. Only around $100 million of the $19 billion invested in inverse ETFs is in unleveraged inverse ETFs.
Additionally, the vast majority of leveraged and inverse ETFs are rebalanced daily, but there are some that are rebalanced monthly or quarterly.
Less frequent rebalancing reduces the drag on returns from volatility over the short-to-medium term, but it also makes ETFs less predictable and useful for traders who purchase them between rebalancing periods.
