Eexchange-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 any investment goal imaginable. With such a variety of products available, it’s important to remember that not all ETPs are the same.
Leveraged and inverse ETPs – often referred to collectively as “geared” – do not work the same way as the simpler one-to-one tracking ETPs. These are complex investments that come with a unique set of risks. (Although this Insight article focuses on suitable ETPs, there are also suitable mutual funds, which are similar.)
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What is a Gear ETP?
Gear ETPs generally seek to provide defined positive or negative multiples of the performance of a given benchmark or index over a given period, such as a day or a month. Among most currently quoted suitable ETPs, the positive leverage factors are 1.5x, 2x and 3x (i.e. one and a half, two and three times) and the inverse factors are -0.5x , -1x, -2x and -3x. The vast majority of leveraged ETPs have a daily leveraged or inverse target and reset their exposure factors every day. This means that the stated leverage or inverse factor target they seek to provide is limited to a single trading day, typically measured from the close of trading one day to the close of trading the following day.
The goal of a tailored ETP with a daily reset is to provide that degree of leveraged or inverse exposure for that single time frame and, importantly, not over longer (or shorter) time frames. (Similarly, a suitable ETP with a monthly target is designed to provide that leveraged or inverse exposure for a specified monthly period.) the daily target.
An example of a leveraged ETP is a leveraged ETF with a 2x daily target that aims to deliver twice the return – positive or negative – of the S&P 500 on any given day. If the S&P 500 gains 2% in one day, the product will aim to achieve a 4% gain. However, such a product is not designed to provide twice the return of the index over longer periods.
Another example is an inverse ETF which seeks to provide -1x, or the inverse, of the performance of the Nasdaq 100 index. This ETF aims to provide a return exactly opposite to that of the index (whether positive or negative) on a given day. If the Nasdaq 100 closes up 1.5%, the inverse ETF would aim to generate a loss of 1.5%. If the index closes down 2%, the ETF should generate a gain of 2%.
Some inverse ETPs seek to provide a multiple of the opposite of the performance of a given index, typically -2x or -3x, over a given period. An example of such a product is an ETF that seeks to offer -3x the daily return of the NYSE FANG+ index. If the FANG+ index drops 3% on any given day, ETF investors can expect gains equivalent to three times the index’s percentage loss, or 9%. On the other hand, if the index gains 3% in one day, the ETF should report a loss of 9%.
To achieve their stated returns, leveraged and inverse ETPs often use a range of investment strategies, including swaps, futures and other derivatives in addition to possible long or short positions in securities. . Note that tailored ETNs, which offer similar leveraged and inverse exposures, do not hold any underlying portfolio of assets, but rather are debt issued by a financial institution.
Since most biased ETPs are only designed to achieve the stated leverage or inverse target on a daily basis, they make no promises as to how their returns will compare over a longer time frame. Returns may differ significantly from the performance (or the inverse of the performance) of their underlying index or benchmark over the same period, which may make these products risky in the long term, or even in the medium term, in especially in volatile investments. markets. Although these products may be held for periods that are inconsistent with the stated objectives, these positions should generally be closely monitored and used by investors who understand what the products are used for and how they may perform in different market environments.
To look closer
Let’s say that at the close of trading on Monday, you have a $100 share of a 2x ETP pegged to an index worth 100. At the close of trading on Tuesday, the index is down 10% at 90, resulting in a 20% loss for the ETP, bringing its value down to $80. Then, on Wednesday, the index closed 10% higher at 99, resulting in a 20% gain for the ETP. However, 20% of $80 is only $16, which means the value of the ETP is now $96.
On both days, the ETP hit its stated target and produced daily returns that were twice the daily returns of the index. But over those days, the index only lost 1%, while the 2x leveraged ETP lost 4%. This means that in just a few days, the ETP lost four times more than the index, not just twice (which represents an actual leverage effect of four times rather than two). However, this is not a “tracking error”, since the ETP has reached its daily target.
Things to consider
Some ETPs, such as Gear ETPs, can be complicated. Before investing, be sure to ask:
- How does ETP achieve its stated goals? And what are the risks? Ask – and make sure you understand – what the products are designed to do and how they might perform in different market environments (e.g. in a volatile market), as well as the techniques the ETP uses to achieve its objectives and the risks they entail.
- What happens if I hold a suitable ETP for more than one trading day? While there may be trading and hedging strategies that justify holding leveraged and inverse ETPs for more than a day, investors with an intermediate or long-term time horizon should carefully consider whether these products are appropriate for their wallet. You could incur losses even if the long-term performance of the underlying index is up for a leveraged ETP or down for an inverse ETP.
- Is there a risk that a geared ETP will not meet its advertised daily target? There is always a risk that not all leveraged or inverse ETPs will achieve their stated target on any given trading day. Make sure you understand the impact this could have on your portfolio’s performance, taking into account your goals and risk tolerance.
- What are the fees and expenses? Leveraged or inverse ETPs can be more expensive than traditional ETPs. Use FINRA Fund Analyzer to estimate the impact of fees and expenses on your investment.
- What are the tax consequences? Leveraged or inverse ETPs can be less tax-efficient than traditional ETFs, in part because daily resets can cause the ETP to realize large short-term capital gains that may not be offset by a loss. There may be other tax-related issues, so it is important to check with your tax adviser about the implications of investing in these products.
Ultimately, not all ETPs pose the same risks and not all ETPs are suitable for all investors. Only invest if you know and are comfortable with the risks associated with these specialist products.
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