Leveraged and inverse exchange-traded products (ETPs) are complex financial instruments that aim to deliver returns calculated as multiples of the underlying indexes they track—and, in Schwab's opinion, are probably not suitable for most investors. In fact, the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) issued a joint warning about the risks of such securities for buy-and-hold investors back in 2009.
The reasons are many. First off, some investors may not be using these funds correctly, as we'll see below. At the same time, such funds are more likely to close than other kinds of funds, often because they've lost a large chunk of their assets. And their tendency toward losses may be obscured by frequent share price splits.
Here, we'll examine these problems and highlight some research into why leveraged and inverse ETPs are so uniquely risky.
Leveraged and inverse strategies
ETP is a blanket term covering both exchange-traded funds (ETFs) and exchange-traded notes (ETNs). Although these products have similar sounding names, they're actually quite different. An ETF is a legal entity that owns a basket of securities, such as stocks, bonds, or commodities. Structured as "investment companies," "limited partnerships," or "trusts," ETFs are legally separate from the companies that manage them. ETNs are unsecured notes (i.e., debt securities) issued by a financial institution that promise to pay the return on some index (or multiple of that index) over a certain time.
Leveraged and inverse ETPs differ from other types of index funds because rather than simply tracking an index, they attempt to provide either a positive or negative multiple of an index’s performance over a specified time—usually just one day (although a few offer monthly or quarterly exposure). For example, a leveraged ETP may offer returns equivalent to 1.5x, 2x, or even 3x the performance of an index during a single day. If the index rose 2%, a 2x leveraged ETP would aim for a 4% return (if it fell, the loss would also be magnified by 2x). Inverse ETPs, on the other hand, attempt to deliver multiples in the opposite direction, so if the index rose 2%, a 2x inverse ETP would generate a negative 4% return.
These funds employ a variety of complex strategies involving derivatives (primarily futures and swap contracts) and aren't designed to be held longer than the reset periods stated in their prospectuses. That means a fund that aims for a daily multiple shouldn’t be held for longer than a single day.
Unfortunately, some investors don't use these products as intended, perhaps thinking that a 2x ETP will offer a cumulative 2x return on whatever the underlying index does during the period they hold the ETP, rather than a series of discrete 2x moves up or down over a series of days. Investors who leave their money in such a fund over a longer period may be surprised to discover their returns are nowhere near the return on the underlying index, perhaps even to the point where they suffer a loss from an investment tracking an index that has risen.
By design, the enhanced volatility of leveraged and inverse ETPs amplifies a portfolio's risk profile. However, there's also a bigger question of whether such funds are inherently unstable over longer periods.
According to Morningstar data, of the over 500 leveraged or inverse ETPs launched in the United States since 2006, more than half have liquidated.1 This is nearly double the closure rate for non-leveraged and non-inverse products. One recent study found that most inverse products tracking stock or bond indexes, and many leveraged and inverse products tracking commodity indexes, lose the vast majority of their assets (at least 95%) within 20 years.2
One potential structural defect of such funds, particularly those with daily timeframes, is that they must constantly rebalance their holdings at the end of each trading day. This can involve significant costs and could create problems when a fund's own rebalancing activity (or hedging by the counterparties to its derivative contracts) influences prices in the underlying market. 3
Another weakness is one they share with any strategy that uses futures contracts—the risk of prolonged contango. At issue here is the fact that futures expire, so a fund that invests in them must constantly replace expiring futures with new ones, a process known as rolling. Contango refers to situations when longer-dated futures tend to cost more than shorter-dated ones. Funds that are stuck rolling their holdings when futures are in contango risk losing money over time, and this pattern of losses is amplified in leveraged funds.
Furthermore, inverse funds face unique challenges when they seek to offer inverse returns on indexes that have tended to rise over time, as many stock and bond indexes have done historically.
The chart below shows the performance of a now-defunct inverse ETP that tracked an index of Asian stocks (excluding Japanese firms). An investor who bought $100 worth of that ETP at its inception date in 2009 and held it in the mistaken assumption they would earn a cumulative 2x return over time would have recovered just $9.30 of her original investment when the fund had to close down in 2016.
Note: Chart shows an investment in the ProShares UltraShort MSCI Pacific ex-Japan. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Screenshots are historical in nature. Past performance is no guarantee of future results.
Here's a second ETP, this one an inverse U.S. mid-cap growth fund that delivered some strong returns during the financial crisis, only to lose more than 90% of its value over the ensuing years. An investor who purchased $100 of this fund at inception in 2007 would have seen her investment grow to $340 as the market cratered. But if she stayed invested, she would have recovered just $7.61 when the fund closed in 2015.
Note: Chart shows an investment in the ProShares UltraShort Russell Mid-Cap Growth. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Screenshots are historical in nature. Past performance is no guarantee of future results.
That's not to say volatility is always good, even for inverse products. In fact, when markets are more volatile, leveraged and inverse ETPs appear more likely to face liquidation risks. Based on data from Morningstar, 90 leveraged and inverse ETPs were liquidated in 2020 during the higher market volatility caused by the outbreak of COVID-19.3 In contrast, when markets were less volatile in 2021, there was just one liquidation of a leveraged or inverse ETP.3
Closings and share price splits
Investors who are considering leveraged and inverse ETPs should also be aware that not all leveraged and inverse ETPs that trend toward nothingness necessarily de-list and close. Some have used reverse share splits—exchanging multiple lower priced shares for a new, single share with a higher price—to prolong their existence.
With a reverse share split, investors will see a higher share price in their accounts, but the number of shares they own will decline, leaving the total value of the investment unchanged. While not all leveraged and inverse ETPs that have been shuttered have undergone a reverse split prior to closing, this technique allows issuers to avoid delisting poorly performing funds that are trending toward penny stock status by raising the share price.
What happens when an ETP closes?
If a leveraged or inverse ETP closes and there is value remaining in the investment, investors looking to recoup what they can should check the issuer's website for important dates and details.
The process for closing an ETF is fairly straightforward. The ETF's manager will announce a date at which the fund will no longer accept creation orders (in other words, no new shares of the ETF will be issued). Next, the fund will be delisted from its exchange, and the manager will begin the process of liquidating the fund’s assets. Finally, cash is distributed to shareholders, usually within a week of delisting. Of course, investors who find themselves holding an ETF that has announced its forthcoming closure can always sell their shares before the delisting date instead of waiting for the final distribution.
ETNs are more complicated to shutter, and the closure process will depend heavily on what was written into the note’s prospectus when it was first issued. One way to close an ETN is to call the note and return its value to investors minus fees. This is known as "accelerated redemption." Accelerated redemptions can be either elective or mandatory. Elective redemptions occur when the note's issuer chooses to call the note before its scheduled termination. Mandatory redemptions occur when the note triggers a condition that was predetermined by its prospectus, such as the value of the note declining below a specified threshold.
However, some ETNs have no provisions in their prospectuses to allow for accelerated redemption. In such cases, the ETN is simply delisted from its national exchange and investors are forced to either wait for the note's scheduled maturity (which could be decades away) or try trading it in the over-the-counter market, generally at a big discount. In general, trading an ETN on the national exchange before delisting is generally a better experience than trading over the counter, so it may be worth it to act quickly if your note is being delisted without accelerated redemption.
If you need to find information about an ETF or ETN that has announced its closure, a good place to begin is the issuer’s website. Most issuers do a good job of describing the closing process and providing key dates on either the product page or in the news/announcements section.
ETPs probably don't make sense for most investors. However, for those who think they can handle the risk, it is important to read the prospectus and fully understand the product's investment objectives, investment strategies, risks, and costs.
1 Morningstar Direct, April 8, 2022.
2 Colby J. Pessina & Robert E. Whaley, "Levered and Inverse Exchange-Traded Products: Blessing or Curse?," Financial Analysts Journal, 2021.
3 Bloomberg, Matt Levine, "Money Stuff: Index Firm Forgot to Update XIV," May 18, 2021.
4 Morningstar Direct, April 8, 2022.