The Leveraged Inverse ETF: Friend or Foe?

Are Leveraged Inverse ETFs: Are they portfolio boosters or the WMDs of the ETF Market?

The days of the friendly fund next door are no more.  Recently, the first leveraged inverse exchange traded funds were introduced to the masses - and they're causing quite the stir.  So what's all the excitement about?
 
We'll start by assuming your basic knowledge of ETFs.  Those investors whose expertise is in line with my mother's - she neither understands nor cares for the "Electronic Funds Transfer" - may have already found themselves lost at our first mention of "inverse"... 
 
Inverse ETFs aim to provide the opposite performance to their benchmark, ie. the same effect as shorting the stocks in the index. An inverse S&P 500 ETF, therefore, is a negative bet on the S&P 500 and aims to provide a daily percentage movement opposite to that of the S&P. So if the S&P 500 rises by 1%, the inverse ETF should fall by 1%; and vice versa.

The goal of the Leveraged Inverse ETF is to provide a multiple of the opposite performance of a benchmark.  For example, the ProShares UltraShort S&P500 ETF aims to provide double the opposite performance to the S&P 500.  So if the S&P 500 rises by 1%, the leveraged inverse ETF should fall by 2%; and if the S&P falls by 1%, the leveraged inverse ETF should rise by 2%.

Tax Advantages:

Leveraged Inverse ETFs may have numerous advantages for bearish investors over shorting index ETFs: (1) Inverse ETFs may be purchased in individual retirement accounts [IRAs]; whereas investors may not short stocks or ETFs in IRAs. (2) Many retail investors have margin accounts that don't pay interest on short balances (the cash generated from selling short a stock or ETF). Purchasing an inverse ETF may therefore turn out to be financially preferable to shorting an index ETF. (3) Purchase of an inverse ETF exposes the investor to limited losses -- the most you can lose is the entire value of the inverse ETFs. Shorting a stock or ETF, in contrast, exposes the investor to potentially unlimited losses.

Finally, be sure to consider the following before you place your first order:

1.  Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs, even proportionate to the level of exposure.

2.  Leveraged ETFs may perform poorly in flat markets, and can underperform their benchmarks in conditions of significant volatility.

3.  Futures-based ETFs may suffer from higher tracking error (i.e. divergence from the target benchmark) because futures are harder to manage than traditional stocks.

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Comments

  • Jeff

    March 25, 2010

    Each time that I have gone into SDS, I've had my head handed to me in a matter of minutes. I'd say it is a foe and a WMD.

  • rypatel

    March 25, 2010

    These products (leveraged inverse ETFs) don't make sense for most investors, unless they are looking to make a short term trade (a few weeks at most). Because the inverse ETFs provide 2x the inverse of the daily movement of a benchmark, like the S&P 500, they are doomed to fail to buyers who hold for a long period.

    For example:

    If the S&P were to fall 5% (lets say from 100 to 95 for simplicity), in one day and you held a leveraged inverse, you would make 10% on your money. Now if the S&P goes back to 100, on the next day it will have gained ~5.25%, meaning that you would lose 10.50%. Therefore, you are out 0.50% even though the S&P is at the same price it was when you shorted by buying the inverse levered ETF.

    Unless you are a believer that the S&P 500 will never recover and always be in a down or flat trend, levered inverse ETFs do not make sense in the long run, since you always need a larger percent gain to recover from a percent drop, i.e you need a 100% gain to overcome a 50% drop. Meaning you will always lose money holding a levered inverse in the long term (given that S&P is always higher for long term periods).

    Now of course this is a simple example of the S&P, and there are other levered ETFs that track other benchmarks, that may be better. However, as a general rule keep in mind what's listed above before buying into levered, inverse ETFs.

    Ryan

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