Lowdown on leveraged and reverse exchange traded products | Personal finance

(FINRA staff)

Exchange-traded products (ETPs), including exchange-traded funds (ETFs), commodity pools and exchange-traded notes (ETNs), are a popular way to invest, with thousands of different products available to target almost every conceivable investment target. With such a wide range of products available, it is important to remember that not all ETPs are the same.

Geared and vice versa – often collectively referred to as “geared” – ETPs do not work in the same way as simpler one-to-one tracking ETPs. These are complex investments that come with a unique set of risks. (While the focus of this Insight article is on leveraged ETPs, there are also leveraged mutual funds that are similar.)

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What are leveraged ETPs?

Leveraged ETPs typically seek to deliver fixed positive or negative multiples of performance for a given benchmark or index over a given time period, such as a day or a month. Among most of the currently listed leveraged ETPs, positive leverage factors are 1.5x, 2x and 3x (i.e. one and a half, two and three times) and inverse factors are -0.5x, -1x, -2x and -3x. The vast majority of leveraged ETPs have a daily leveraged or reverse goal and reset their exposure factors every day. This means that the stated leverage or inverse factor objective they seek to provide is limited to a single trading day, generally measured from the closing of the trade from one day to the end of the trade the next day.

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The purpose of a geared ETP with a daily zero is to provide that degree of geared or reverse exposure for the individual period and, more importantly, not over longer (or shorter) periods. (Similarly, a leveraged ETP with a monthly target is designed to provide the leveraged or reverse exposure for a specified monthly period.) Holding a leveraged ETP for a period shorter or longer than its target may lead to results that may deviate significantly from the daily goal.

A leveraged ETP example is a leveraged ETF with a 2x daily target that aims to deliver the double return – positive or negative – of the S&P 500 on any given day. If the S&P 500 rises 2 percent in one day, the product will aim to deliver a gain of 4 percent. However, such a product is not designed to provide double the return on the index over extended periods.

Another example is a reverse ETF that seeks to deliver -1x, or vice versa, of the performance of the Nasdaq 100 index. This ETF aims to deliver a return that is exactly the opposite of what the index returns (whether positive or negative) on any given day. If the Nasdaq 100 closes 1.5 percent, the reverse ETF will aim to return a loss of 1.5 percent. If the index closes 2 percent, the ETF should return a gain of 2 percent.

Some inverse ETPs seek to deliver a multiple of the opposite of a given index’s performance, usually -2x or -3x, over a given period of time. An example of such a product is an ETF that seeks to deliver -3x of the daily return of the NYSE FANG + Index. If the FANG + index falls 3 percent on any given day, investors in the ETF can expect gains equal to three times the index’s percentage loss, or 9 percent. On the other hand, if the index rises 3 percent in one day, the ETF should return a loss of 9 percent.

To achieve their stated returns, leveraged and reverse ETPs often use a variety of investment strategies, including swaps, futures and other derivatives in addition to possible long or short positions in securities. Note that leveraged ETNs that provide similar leveraged and reverse exposures do not have an underlying portfolio of assets, but instead are debt issued by a financial institution.

Since most leveraged ETPs are only designed to achieve the stated leveraged or reverse goal on a daily basis, they make no promises about how their returns will be compared over an extended period of time. Returns can deviate significantly from the performance (or vice versa of performance) of their underlying index or benchmark over the same time period, which can make these products risky long-term or even medium-term investments, especially in volatile markets. Although such products may be stored for periods that do not meet the stated objectives, such positions should generally be closely monitored and used by investors who understand what the products are designed for and how they may behave in different market environments.

A closer look

Let’s say that at the close of trading on Monday you have a stock of 100 USD of a 2x ETP linked to an index with a value of 100. At the close of trading on Tuesday, the index has fallen 10 percent to 90, resulting in a loss of 20 percent for the ETP, bringing its value down to $ 80. So on Wednesday, the index closes 10 percent at 99, resulting in a gain of 20 percent for ETP. However, 20 percent of $ 80 is only $ 16, which means that the value of the ETP is now $ 96.

Both days, the ETP reached its stated goal and produced daily returns that were twice the daily index returns. But during those days, the index lost only 1 percent, while the 2x geared ETP lost 4 percent. This means that in just a few days, the ETP lost four times as much as the index, not just twice (which represents an actual leverage of four times instead of twice). However, this is not a “tracking error” as the ETP reached its daily goal.

Things to consider

Some ETPs, such as leveraged ETPs, can be complicated. Before investing, be sure to ask:

  • How does ETP achieve its stated goals? And what are the risks? Ask about – and make sure you understand – what the products are designed to do and how they may behave in different market environments (eg in an unstable market), as well as the techniques that ETP uses to achieve its objectives and the risks involved.
  • What happens if I have a leveraged ETP for more than one trading day? While there may be trading and hedging strategies that justify holding leveraged and inverse ETPs for longer than a day, investors with a medium or long-term time horizon should carefully consider whether these products are appropriate for their portfolio. You like losses even if the long-term performance of the underlying index is up for a leveraged ETP or down for a reverse ETP.
  • Is there a risk that a leveraged ETP will not meet its stated daily target? There is always a risk that not all leveraged or reverse ETPs will meet their stated target on any given trading day. Make sure you understand the impact this may have on your portfolio’s performance, taking into account your goals and your risk tolerance.
  • What are the fees and expenses? Geared or reverse ETPs can be more expensive than traditional ETPs. Use FINRA’s Fund Analyzer to estimate the impact of fees and expenses on your investment.
  • What are the tax consequences? Leveraged or reverse ETPs may be less tax efficient than traditional ETFs, in part because daily resets may result in the ETP realizing significant short-term capital gains, which may not be offset by a loss. There may be additional tax-related issues, so it is important to check with your tax advisor about the implications of investing in these products.

The bottom line is that not all ETPs have the same risks, and not all ETPs are right for every investor. Only invest if you are aware of and familiar with the risks associated with these specialized products.

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