In April of this year, the S&P 500® Index returned –8.8%, making it the weakest month in the market since March 2020. But a handful of exchange-traded products (ETPs)—a term covering exchange-traded funds (ETFs) and exchange-traded notes—bucked that trend: Six ETPs returned more than 50% over the same period.1
Lured by such impressive gains, some investors have flocked into similar funds, often without a full understanding of the associated risks. "Leveraged and inverse ETPs are complex financial instruments that use derivatives or total return swap contracts to magnify returns," says Emily Doak, director of ETF Research at Charles Schwab Investment Advisory. "But they can also compound losses, so investors need to be sure they know what they're getting into before they take that risk."
In particular, investors should be mindful of:
- Time frame: Unlike a traditional index-tracking ETP, which attempts to match the returns of its benchmark index, a leveraged ETP typically attempts to boost the daily returns of its underlying index by a multiplier—usually 2x or 3x. An inverse ETP uses the same approach, aiming to deliver the opposite daily return of its underlying index, or a multiple thereof. "However, daily volatility can cause leveraged and inverse ETPs to behave in ways many investors do not expect," Emily says. "For example, if the market moves against you, losses are going to compound much faster than they would with a traditional ETP." Thus, holding such funds for longer than a day is very risky.
- Fees: Because leveraged and inverse ETPs are managed to a greater degree than traditional index funds, their operating expenses are much higher than those for index funds. Expect to pay close to 1% in fees, on average, for leveraged ETPs—versus just 0.18%, on average, for index-tracking ETPs.2
- Taxes: Leveraged and inverse ETPs reset their exposure each day, which could lead to more frequent short-term capital gains distributions than with traditional ETPs. "High-income earners, in particular, should discuss the tax consequences of these products with an advisor before investing," Emily says.
- Liquidation: Roughly 52% of leveraged and inverse ETPs have been liquidated since 2006—compared with 28% for all other funds3—generally due to a catastrophic loss of assets. "Unfortunately, there are many stories of shareholders losing everything they invested in such funds," Emily says. "Even if an ETP doesn't liquidate—it can reduce the number of outstanding shares, for example, thereby increasing the value of those that remain—investors' capital may still be decimated."
As attractive as the outsize returns of leveraged and inverse ETPs can be, the risks are probably too great for most long-term investors. "Unless you're trading daily and fully understand their complexity," Emily says, "it's probably best to steer clear of them."
1Schwab.com.
2Morningstar Direct, as of 04/2022. Averages are asset-weighted net expense ratios.
3Morningstar Direct, as of 04/2022.
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Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. For more information on indexes please see schwab.com/indexdefinitions.
Exchange-traded notes (ETNs) are distinct from exchange-traded funds (ETFs). ETNs are debt instruments backed by the credit of the issuer and as such bear inherent credit risk. ETNs are not generally appropriate for the average investor. To find out more about ETNs, please read "Exchange Traded Notes: The Facts and the Risks."
Leveraged ETFs seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETFs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding, aggressive techniques, and possible correlation errors, leveraged and inverse ETFs may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETF and its underlying index or benchmark, so returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETFs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives, and options can increase ETF volatility and decrease performance. Investors holding these ETFs should therefore monitor their positions as frequently as daily. To find out more about leveraged and inverse ETFs, please read "Leveraged and inverse products: What you need to know."
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