ETFs have gained tremendous popularity in recent years due to several advantages that they offer to investors, including low costs, tax efficiency and transparency. As of the end of March 2012, assets in US-listed ETFs totaled approximately $1.2 trillion, up 12% year-over-year, per the ETF Industry Association.
Most of these funds can be used by investors very easily and effectively to achieve their investment aims. However not all ETFs are straightforward; some of them, like the leveraged and inverse ETFs, are highly complex financial instruments which should be used only by the professionals who understand them properly.
Leveraged and inverse ETFs, also known as geared ETFs, seek to track a multiple or opposite/opposite multiple of an underlying index. To accomplish their objectives, these ETFs employ various investment strategies through the use of swaps, futures contracts, and other derivative instruments. These ETFs are designed to achieve their stated performance goal on a daily basis. Over a period longer than one day their performance can differ significantly from their stated daily performance objectives, due to the compounding factor.
To illustrate, let us take the simple hypothetical example of an index with a starting value of 100, and a loss of 10% on Day 1, followed by a gain of 10% on Day 2.
Day 1 Closing Value
Day 2 Closing Value
Difference from expected return
So, at the end of Day 2, the index ended with a loss of 1%, but the leveraged and inverse ETFs lost between 1% and 9%.
Now let us look at the real-world example of the performance of the S&P 500 and related leveraged and inverse ETFs during 2011. S&P 500 returned 2.11% during the year but all geared ETFs resulted in losses to the investors who held them for the full year.
In the above case, if investors expected the three times leveraged and inverse leveraged ETFs to deliver returns of 6.33% (2.11*3) and -6.33% (2.11*-3) respectively, then they were in for a rude shock, as the funds actually lost 11.88% and 32.35% respectively during the year.
These examples clearly illustrate that such ETFs should not be held as long term investments. Though compounding can have both favorable and adverse effects on the return, in times of volatility the effects are usually negative.
Investors also need to keep in mind that leveraged or inverse ETFs are usually more costly than traditional ETFs. Also since they reset daily, they may be less tax-efficient than traditional ETFs. However unlike other common ways to gain inverse exposure such as short selling, buying put options or selling futures, the maximum loss for geared ETFs is limited to the value of the investments.
We are not saying that these geared ETFs should not be used; the question is how they should be used. These investments are specialized tools that need to be monitored and rebalanced on a daily basis in order to maintain the desired exposure. Professional investors and traders use them very effectively for short-term trades, either to make bets on the movement of certain types of investments or to hedge a portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.