Leveraged and Inverse ETFs: Not Right for Everyone

October 20, 2011

Michael Iachini
CFA, CFP®, Managing Director of ETF Research, Charles Schwab Investment Advisory, Inc. 

Exchange-traded funds (ETFs) have been steadily increasing in popularity since their introduction in 1993. These investment vehicles can be used to help diversify a portfolio at a low cost or to make tactical investment moves.

Not all ETFs are so straightforward, though. A significant segment of the ETF market is made up of leveraged funds—ETFs that seek to provide a multiple of the returns on a given index. There are also many inverse ETFs that aim to go up when the market goes down, and vice versa. While these may sound intriguing, there are reasons for caution.

Let's start with leveraged ETFs

These funds often have a multiple in their names, such as 2x or 3x, or a descriptor such as "Ultra." This means that the ETF aims to deliver two or three times the return on its stated index.

So, a fund that's a "2x S&P 500 Index®" ETF is trying to deliver twice the return of the well-known Standard and Poor's 500 Index. If you want to bet on a market rally, these ETFs might seem to let you take extra advantage of a market increase without coming up with extra money to invest.

The problem is that if you hold these ETFs for longer than a day, you may not get the multiple of the index return that you typically would expect—and you'll sometimes get something far worse. This is because of the effects of compounding (sometimes called "beta slippage"). Leveraged ETFs generally aim to deliver their stated multiple of the index return on a daily basis, which means that holding the ETF longer than a day, especially when the index has large ups and downs, can lead to trouble.

A leveraged ETF example

Consider a hypothetical ETF that promises twice the return of an index: Let's say you buy a share of the ETF for $100 while the underlying index is at 10,000. If the index goes up 10% the next day to 11,000, your ETF should go up 20%, to $120. If the index goes from 11,000 back down to 10,000 the next day, that's a decline of 9.09%, which means that the ETF should go down twice this much, or 18.18%. A decline of 18.18% from the $120 price of the ETF should leave it at $98.18. So even though the index ended up right back where it started, the ETF is down 1.82%!

Why does this happen? Well, the ETF rebalances its assets every day so that it will deliver the right multiple of the index's returns on that day. This means that if the index goes up in value, the ETF will have to increase its exposure to the index for the next day in order to get the right multiple, and if the index goes down in value, the ETF will have to decrease its exposure. If the index keeps moving in the same direction every single day, this should result in better-than-expected returns for the longer period.

However, any reversals in the index direction should leave a leveraged ETF worse off than would be expected based on its multiple. Because of this phenomenon, investors who plan to hold their investment for longer than a day should be cautious when approaching this type of ETF.

If you're looking for leveraged exposure over periods longer than a day, consider a margin account or the use of options. However, be aware than any use of leverage will increase your risk exposure and can lead to greater losses, and purchasing leveraged ETFs on margin or buying options on these ETFs will only increase the impact of the compounding issue.

What about "monthly leverage" ETFs?

Note that there are a few exchange-traded products with "monthly leverage" in their names whose leverage resets on a monthly basis. If your holding period is exactly one month, these funds should track the expected multiple of the benchmark; for longer or shorter periods, however, compounding effects will generally still be problematic.

How do inverse ETFs compare?

Inverse or "short" ETFs have a similar compounding problem. An inverse fund tries to deliver returns that are the opposite of the index's returns. So, if the index goes up 1%, the inverse ETF should go down 1%, and vice versa. Many investors became interested in these "bear market" funds during the market downturn of 2008, hoping to profit in a falling market.

Leveraged inverse ETFs also exist, providing exposure equal to some multiple (two or three times) of the opposite of the index return. To see the compounding problem, imagine the same example as before, except with a fund that provides the opposite of the index's daily return.

An inverse ETF example

If the index falls from 10,000 to 9,000 in one day, a decline of 10%, then an inverse ETF purchased for $100 should rise to $110—an increase of 10%. If the index then climbs from 9,000 back to 10,000 on the next day, this is an increase of 11.11%. The ETF should fall by 11.11%, from $110 down to $97.78.

Again, even though the index ended up where it began, the ETF performs worse than expected because of the daily rebalancing. As with "long" leveraged ETFs, these inverse funds should provide better-than-expected returns if the index moves only in one direction, but reversals in direction will work to the detriment of the fund.

Inverse and leveraged

If an ETF is both inverse and leveraged, the problem only grows. Investors seeking inverse exposure for longer than a day may want to consider options or short selling. However, be aware that both of those strategies have costs and risks of their own, in addition to losing money if the market rises, as it historically has done in the long run.

These examples are not merely hypothetical—in markets that move up and down, leveraged and inverse funds have underperformed what an investor might expect.

For instance, look at the table below, which shows the returns of the S&P 500® index for the 12-month period ending September 30, 2011, and compares it to the returns of a 2x leveraged, an inverse ETF, and a -2x leveraged inverse ETF that are all based on that index.

As you can see, the index was up 1.14% for the period. Based on that return, the expectation would be for the leveraged fund to return 2.29%, -1x inverse fund to return -1.14% and -2x inverse fund to return -2.29%.

All three funds performed far worse than the expectation due to the problem of compounding (and to a lesser degree due to fund expenses). In fact, all three funds had negative returns, despite the fact that the index itself rose!

S&P 500 index return: 1.14%

Source: Morningstar. Trailing 12-month total returns as of September 30, 2011.

Be cautious

Ultimately, while there may be limited occasions where a leveraged or inverse ETF may be useful for some types of investors, it is extremely important to understand that, for holding periods longer than a day, these funds may not give you the returns you may be expecting. Proceed with extreme caution.

If you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.