The popularity of exchange-traded funds (ETFs) has led to the spin-off of second-order ETFs that are designed to provide investors with downside/bearish (often referred to as inverse) exposure and/or leveraged (sometimes referred to as ultra) returns. To construct these ETFs, complex financial instruments such as options, swaps and futures are arranged and embedded into the ETFs portfolio. While this may sound onerous and foreboding, these ETFs can be effective tools if you fully understand what they do, how to use them, and the risks involved. The purpose of this article is to help you understand what leveraged and inverse ETFs are designed to do, while detailing some of their risks and potential benefits. It's important to note that these instruments are not for the average investor: They involve a great deal of risk and don't always work as intended. Furthermore, although an ETF may be designed to provide investment returns that correspond inversely to, and/or by multiples of, the performance of an underlying index, due to expenses, potential tracking error, market supply-and-demand conditions and other factors, there can be no guarantee that exact correlation will be achieved.
Allocating idle cash: Say you have some idle cash that you want to use to gain short-term market exposure, but you want the potential for leveraged returns and are willing to accept the risks. By using a leveraged ETF, you may be able to obtain your desired result with less cash. For example, let's say you have a 20% cash allocation that you want to temporarily expose to the performance of the market. Rather than investing all 20% back into the market, you could keep 10% in cash and invest 10% in a leveraged ETF designed to return twice the performance of the broad market. Theoretically, you'd initially have an additional 20% exposure to the market's performance, but you would still have 10% in cash. Because the ETF is designed to approximate twice the performance of the underlying index for the day only, your additional exposure to market performance after the first day would depend on the volatility of the underlying index. Increasing your exposure: You can use leveraged ETFs to try to obtain exposure in excess of 100% to the overall market. You can do this without accessing the features of a margin account. In the prior example, say you deployed the entire 20% cash balance into a leveraged ETF. Initially, you would have 80% of your portfolio in stocks and another 40% market exposure via the ETF, as the 20% investment in the leveraged ETF provides initial two-to-one market exposure. Now you have 120% exposure to the market and could potentially gain or benefit at a leveraged rate of return. Reducing risk or hedging: While leveraged and inverse-leveraged ETFs can be extremely risky and speculative when used on their own, they can also be used to reduce or hedge risk when combined with a complete portfolio. You might be 100% invested in the market, but concerned about a short-term market drop and yearning to get more defensive. Selling off 10% of your holdings would bring your exposure down to 90% of your capital. You could use the 10% to purchase an inverse-leveraged ETF to approximate a 20% short hedge against the portfolio, bringing your total exposure down to about 70%. Thus, you could theoretically turn a 100%-at-risk portfolio into a 70%-at-risk portfolio by executing a 10% liquidation and commensurate purchase of an inverse-leveraged ETF. Note that over longer periods, the hedging power can be lost. As we have discussed, this is because the index value upon which the ETF's performance is based changes every day. If the rest of your portfolio is different from the ETF's underlying index, the hedge will be imperfect.