Leveraged and Inverse ETFs

If you’re very confident that a particular share or market is going to go up, it can be frustrating when you know you don’t have much money available to back your belief.

If you’re in that situation, one option is to invest ‘on margin’, where you’re effectively borrowing to invest. Another option is spread betting or using contracts for difference, where once again you’re effectively borrowing to invest. All three options magnify your profits if things go well, but they can magnify your losses too. Spread betting can be particularly painful if markets go against you.

So that leaves us with leveraged ETFs as another possibility for bullish investor. Most leveraged ETFs offer either a 200% or 300% return on the share or index you’re investing in. So if you invest in a FTSE 100 2x ETF, the idea is that your ETF will rise in value by 10% if the FTSE 100 index rises 5%. And if the Footsie falls 5%, then your FTSE 100 2x ETF will fall by 10%. There are also inverse ETFs that will move in the opposite direction of a share or index. So if the FTSE 100 rises by 5%, an Inverse FTSE 100 ETF will fall by 5%.

The first leveraged ETFS were launched in the US in 2006, and they’ve proved to be popular vehicles. But the reality is they’re only appropriate for short-term traders, not investors. That’s because the vast majority of these ETFs rebalance daily. Consider, for example, the L&G 2x FTSE 100 ETF (LUK2). It promises twice the return of the FTSE 100. If the Footsie drops by 5% on the first day, then the ETF should drop by 10%. In cash terms, if the ETF share price was ¬£10 at the beginning of the day, it would fall to ¬£9 at the end of the day.

On day two, if the Footsie rebounds and goes up 5%, the ETF will rise by 10% to £9.90, down 1% for the two days. But the FTSE’s two-day return would be down just 0.25%, a fall that is four times smaller than the ETF’s. As the days and weeks go by, the divergence between the performance of the index and the performance of the ETF will grow. Because of this divergence, it only makes sense to use leveraged ETFs for short periods – days or weeks at most.

Inverse ETFs suffer from exactly the same defect, so once again they should only be used as short-term trading tools.

It’s also worth noting that leveraged and inverse ETFs are synthetic products. In other words, they don’t invest in the underlying assets such as shares, currencies or commodities. Instead they borrow and purchase swaps and futures to mimic the performance of the underlying assets. As with all synthetic ETFs there’s a small counterparty risk here: the risk that the bank that provides the swap won’t be able to meet its obligations.

The other issue here is cost. The charges for inverse and leveraged ETFs are normally higher than for conventional ETFs, and of course, there will be a transaction cost every time you buy or sell one of these ETFs.

There are also a small number of monthly reset ETFs, but the reset period is normally set at the beginning of the month not when you purchase the ETF. So to get the full benefit of the monthly reset, you’ll need to buy on the day of the reset.

For most investors, inverse and leveraged ETFs are best avoided.

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