By Kevin Grewal, Editorial Director at www.SmartStops.net
Both leveraged and inverse ETFs are index funds that amplify the returns of an underlying index. They are relatively new to the market, but are gaining tremendous ground as traders and investors become more knowledgeable of both their benefits and drawbacks.
Leveraged ETFs are index funds which try to amplify returns from an underlying index using leveraged money. They keep a constant leverage level, which can double or triple daily returns. Leveraged ETFs use derivatives like index options, index futures and equity swaps to reduce to increase or reduce market exposure and they do this on a daily basis, therefore there is no guarantee of amplified annual returns. Take for example, a fund that doubles returns, if the index returns 1% for the day, then the leveraged fund rises 2%.
Inverse ETFs are ETFs that are created by using derivatives to create profits when the underlying index declines in value. In layman’s terms, inverse ETFs track the reverse, or opposite of the market. They short the market and make money when the market is falling. Some of the most common inverse ETFs include the following:
the UltraShort S&P 500 ProShares (NYSEARCA:SDS), which aims to track twice the inverse of the daily performance of the S&P 500 and carries an expense ratio of 0.91%.
the UltraShort QQQ ProShares ETF (QID), which seeks to track twice the inverse of the daily performance of the NASDAQ 100 and holds an expense ratio of 0.95%
the UltraShort Russell 2000 ProShares (NYSEARCA:TWM), which seeks to track twice the inverse of the daily performance of the Russell 2000and holds an expense ratio of 0.95%.
the UltraShort Financials ProShares (NYSEARCA:SKF), which seeks to track twice the inverse of the daily performance of the Dow Jones U.S. Financials Index and holds an expense ratio of 0.95%.
So now we know what these investment tools do and how they work, the question at hand is how to use them. Leveraged and inverse ETFs are great tools to use for short-term trades who are knowledgeable and seasoned investors. On the plus side, they enable traders and speculators to get more bang for their buck, exploit quick market swings, bet against the markets, have an additional hedging tool in their arsenal and the ability to gain leveraged access to the markets in a liquid vehicle without trading on margin.
Critics of leveraged and inverse ETFs state that market volatility play havoc with performance over longer periods and daily compounding of the leveraged ETF takes its toll. Additionally, they argue that losses are magnified when moving against the trade. Both of these arguments are true if they are improperly used.
Critics also state that an investors ability to be profitable depends largely on whether one correctly guess the short-term direction of the market and how long one stays invested. Other issues with leveraged ETFs are tracking errors and borrowing complexities.
Lastly, critics are quick to preach the impact that leveraged ETFs have on the commodities exchanges. As these funds amplify commodities returns, a problem arises when the risks of contango and backwardation are present. If the current price of oil is lower than the future price, it’s a classic case of contango. In the opposite situation, it’s known as backwardation. Most commodity funds buy the “near month” contract, then roll it over before it expires and the next month’s contract is bought (known as “rolling forward.”) The risk is that a negative roll yield could cause the net asset value (NYSE:NAV) of a fund to drift from the spot price.
Leveraged ETFs in conjunction with contango or backwardation could cause the funds to deviate extremely from its underlying index.
At the end of the day, if one knows how to use these tools they are great to add to an arsenal. With the proper exit strategy, informing of you when an uptrend is ending and issuing a sell trigger to stop the bleeding, which can be found at www.SmartStops.net, these controversial tools will enable one to maximize the performance of a portfolio.