What Are Leveraged & Inverse ETFs & ETNs & How Do They Work?

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On screen text: Leveraged and Inverse. ETF ETN. Exchange-Traded Fund. Exchange-Traded Note.

Animation: Sample chart of a 2X ETP.

WOMAN: Leveraged and inverse ETFs and ETNs are types of ETPs, or exchanged-traded products, designed to multiply or invert the performance of a certain index or benchmark.

Animation: Sample charts of leveraged and inverse ETPs.

WOMAN: For example, investors might buy a leveraged ETP in an attempt to potentially boost returns on a stock index they think will go up or an inverse ETP to provide the potential for temporary protection from falling markets. While the concept may sound simple, leveraged and inverse ETPs are complex and can be risky. Before using these products, investors should understand what they're designed to do, and what risks they carry.

Animation: Sample chart of Index, 2x, 3x, 4x ETPs

WOMAN: Let's start with leveraged ETPs. Leveraged ETPs are designed to double, triple, or quadruple the returns of an underlying index for one day. The amount of leverage is commonly indicated by their names, which often include terms like 2x, 3x, 4x, or ultra.

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WOMAN: ETPs primarily provide the leverage needed by entering into an agreement called a "swap" with large investment banks but may also use futures and options contracts from a stock index they want to emulate.

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WOMAN: For example, let's say we have a leveraged ETP that's designed to produce twice the returns of a stock index's daily performance. For easy math, we'll say that the ETP is trading at $100 per share and the underlying index is at 10,000.

If the index rises 10% to 11,000, shares of the ETP will rise about 20% from $100 to $120 for a gain of $20 per share. Note, it is the leverage that provides this extra return. However, if the index falls back to 10,000 or 9.09%, the ETP will fall twice as much, or 18.18%, pushing the price down to $98.18 per share for a loss of almost $22 per share. As you can see, the leverage led to large gains and losses, and the ETP ended up lower than the starting price even though the index ended where it started.

Now let's look at inverse ETPs. Inverse ETPs are designed to move in the opposite direction of the underlying index. The names of these products may include terms like "short" or "bearish." Here's an example of how this works. We'll assume the ETP is trading at $100 per share and the underlying index is at 10,000. If the index falls 3% or 300 points to 9,700, the ETP will rise 3% to $103 per share. If the index rises 3%, the ETP will fall 3% to $97 per share.

Animation: Illustrated ETP certificate labeled Inverse and 2x Inverse.

WOMAN: Additionally, inverse ETPs may also be leveraged, magnifying the potential gains or losses.

Animation: Illustrated woman in a room with a computer giving her the option to buy a leveraged or inverse ETP.

WOMAN: It's important to realize that leveraged and inverse ETPs are only designed to achieve this performance over a fixed period, typically a day. This means leveraged and inverse ETPs are not meant to be buy-and-hold investments.

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One reason for this is that at the end of the trading session, these ETPs "reset" their investment strategies in order to maintain their leverage ratio. For example, if the index goes up in value, the ETP will have to increase its exposure to the index for the next day in order to get the right multiple. Resetting can result in a difference in the returns of the ETP compared to the underlying index.

Animation: Sample Index and ETP charts going in different directions.

The resetting difference could compound losses or even cause losses despite the underlying index moving in the desired direction, especially in volatile markets. Furthermore, in lightly traded markets (such as VIX futures), the resetting of leverage and inverse ETPs has itself contributed to increased volatility.

On-screen text: Preset Minimum Value.

Another way that price volatility can lead to losses is if major movements in the underlying index are so extreme, that the losses result in the leveraged ETP falling below a fund's preset minimum value. If this happens, the leveraged ETPs may be forced to close.

On-screen text: Close ETF. Close ETN.

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Fund closures can lead to major losses for investors. Closure can be particularly complex for ETNs, which are structured differently than ETFs. While it may feel a bit like alphabet soup, it's important to understand how ETNs are created and how market volatility could lead to an ETN being closed.

Animation: ETN certificate and Financial Institution building.

Unlike an ETF, which provides ownership in a basket of securities, an ETN is actually a debt instrument issued by a financial institution and structured more like a bond.

On-screen text: Index. ETN. Maturity 20 Years. Principal.

Instead of interest payments, the ETN promises returns linked to an underlying index over a certain period of time and to return the principle at maturity, usually 20 to 30 years out. This structure allows ETNs to very closely track the performance of their underlying index, but it also comes with additional risks.

First is credit risk. If the financial institution issuing the ETN fails, investors may only be entitled to receive pennies on the dollar.

On-screen text: Closure Risk. Close ETN. Changes to Accelerated Redemption.

There's also closure risk. Some ETNs may be "called" before maturity. The process of calling the note is known as an "accelerated redemption," which allows the issuer to close the ETN and return the value of the note, if any, to investors after a certain date. If the value of the note has dropped, investors can experience losses.

However, not all ETNs allow accelerated redemption. Instead, market conditions may force the issuers to delist ETNs from a national exchange, making it difficult for investors to close their position. Investors are forced to either wait for the note's scheduled maturity, which could be decades away, or try to sell their shares in the over-the-counter market, likely at a substantial loss.

So, with these risks in mind, what should you do if you want to trade a leveraged or inverse ETP?

On-screen text: Understand the product. ETP. Changes to list of Call Features, Maturity, Costs, Fees. Changes to Prospectus. Bid 55. Ask 55.25. Distributions. Net Asset Value.

First, make sure you understand the product and its goals and check to see if it meets your objectives and risk tolerance. Also, familiarize yourself with the ETP's call features and maturities, and its costs and fees. All this can be found in the prospectus and the pricing supplement, which also contains a history of whether the ETP has traded at a premium or a discount to its underlying net asset value.

You should also check the cost of trading the ETP, known as the product's bid-ask spread.

If you're investing in a taxable account, you may want to review the product's history of distributing capital gains. Although ETFs are usually tax-efficient, certain strategies may result in a higher tax burden than other types of ETFs.

On-screen text: Understand the Product. Determine Broker Requirements. Determine Entry and Exit Strategies.

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Next, check with your broker to see what rules they have around trading leveraged and inverse ETFs and ETNs. Some brokerages will require you to sign an agreement acknowledging the risks.

Finally, determine your entry and exit strategies before placing the trade. Have a plan for what you would do if the trade goes badly to avoid large losses. Remember, if you do decide to hold a leveraged ETP longer than a day, you may not get the returns you expected. You may even experience a loss despite the underlying index moving in a favorable direction.

Leveraged and inverse ETPs are complex products that require caution. Take time to familiarize yourself with the benefits and risks of these investments.

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