ETF Education: The Problem With Inverse/Leveraged ETFs

[This article appears in our January 2018 issue of ETFR Report.]

ETFs let investors express a vast number of viewpoints—including if an investor expects prices to fall, or wants to magnify a return.

Leveraged ETFs allow investors to take a chance to enhance the risk they’re taking on a daily basis, says Todd Rosenbluth, director of ETF and mutual fund research for CFRA. These funds often are designed to have returns two or three times their benchmark on a daily basis. Meanwhile, inverse ETFs allow investors to easily short an index if they believe the price will fall.

But the vehicles used to place these trades—leveraged and inverse ETFs—often have poor returns.

“They’re intended to move more aggressively than the broader market that they’re representing. If the trend flips, you can get hurt very quickly. You can make money very quickly, and it’s usually the getting hurt very quickly that investors tend to not see coming,” Rosenbluth said.

Daily Resets Erode Returns
The problem investors run into with these funds occurs when people hold them for more than a day or two, say Rosenbluth and Brett Manning, senior market analyst at Briefing.com.

Because they reset daily, arithmetic works against buy-and-hold investors, Manning says.

Manning used a hypothetical example to explain the long-term drag for leveraged performance. If an index on Monday is at 10, on Tuesday rises to 11 and on Wednesday falls back to 10, a double-leverage long ETF would rise to 12, but then fall to 9.82. It rose 20% on Tuesday, but fell 20% on Wednesday. Because a 20% drop from the higher number leads to a larger nominal decline, the investor loses money.

Conversely, in a double-leverage short using the same index, the investor’s ETF would fall to 8, but only rise to 9.46, because the rise is off a smaller number.

The same mathematical problem arises in a market that is range-bound, Manning notes.

Even in range-bound markets, leveraged and inverse ETFs eat away at long-term returns because the moves are asymmetrical. Because the moves are magnified, the declines from higher levels are compounded, and the rebounds don’t get investors back to par because it takes more of a rally to make up the losses. So when prices drift around in range-bound markets, it’s a little like death from a thousand cuts because investors usually don’t break even.

Market Directions Change Quickly
Some investors like to use leveraged/inverse ETFs when they see a market that has a strong directional trend, such as the drop in the oil market in late 2014 and early 2015. But part of the poor performance of these funds exemplifies how quickly strong directional market trends can change, Rosenbluth and Manning say.

“You may have a thesis, but you have to be an expert in understanding price moves, and these are geared to a retail investor who doesn’t have a lot of time to formulate those ideas. The payoff is not going to be that way. If they get lucky, it’s like winning the lottery. But if you don’t get out in time, you can quickly lose gains,” Manning said.

Because of the volatile nature of these ETFs, many brokerage platforms don’t allow them for advisors to use to put forward trades, Rosenbluth said, “because they’re more akin to gambling than investing.”

Rosenbluth and Manning say these ETFs are really designed more for frequent trading, or to try and time the market. Still, they cautioned investors using them.

“They can serve a purpose, but they can also be something that causes investors to lose money faster than they anticipated,” Rosenbluth said.