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As exchange-traded funds (ETFs) have grown in popularity, the types of ETFs have grown as well.

In addition to traditional ETFs that track well-known stock market indexes and ETFs designed to track the movements of a specific sector, investors have the option to invest in inverse ETFs, leveraged ETFs, or even inverse leveraged ETFs.

Leveraged and inverse ETFs use a variety of investment strategies—including the use of futures contracts, short selling, buying put options, and employing other strategies of leverage—that are designed to either magnify the performance of the index the ETF is designed to track, or perform in the reverse direction of the underlying index.

An inverse ETF increases in net asset value as the underlying assets decrease in value, and vice versa.

Leveraged ETFs are designed to return twice or more of the underlying index value.

There are also inverse ETFs that provide leverage. This means that if the underlying index goes up, the value of the ETF moves down to an even greater degree, losing two or even three times as much, depending on the leverage. On the other hand, if the underlying index goes down, the value of the ETF goes up to an even greater degree.

While these ETFs sound like a great way to leverage the market or to bet against it, the mechanics of these investments are complicated. Leveraged and inverse ETFs use daily rebalancing. Behind the scenes, managers are constantly trading derivative securities in order to maintain the correct leverage and inverse relationship the ETF advertises. That means that these ETFs perform as advertised on a daily basis. But that performance does not necessarily translate into the advertised performance over the longer term. In other words, an inverse ETF will on a daily basis move in the opposite direction of its underlying index, but its longer-term performance will not necessarily be the mirror image of the long-term performance of the index.

ETFs that use leverage typically include the word Ultra in their names. Typically, they will track two to three times the underlying index.

As stated before, the leveraged ETFs aim to deliver their stated multiple of the index return on a daily basis.

Let’s look at an example. ETF ABC uses 200% leverage against index XYZ. An investor purchases one share of ABC at $50 while the index XYZ is at 1,000. The next day, index XYZ rises to 1,100, an increase of 10%, so shares of ABC should increase by 20% to $60.

Now, let’s say index XYZ falls back to 1,000 the next day. This is a decline of 9.09%. The value of ABC will fall by twice that amount, or 18.18%, to $49.09. After two days, the index value is unchanged, but the share price of the ETF will have fallen 1.82% (from $50 to $49.09) due to the daily rebalancing.

The stated leverage essentially refers to an investor holding the ETF for one day, or if the index keeps moving in the same direction every single day. Any reversal in the index value will leave a leveraged ETF worse off than would be expected based on its stated leverage.

Inverse funds are also priced on a daily basis, leading to similar issues as with leveraged ETFs.

Let’s look at a similar example. An investor purchases an inverse ETF, ABC, for $40 per share. If the ETF’s underlying index then falls from 1,000 to 900 in one day, that is a decline of 10%; shares of ABC would rise by 10% to $44. If the next day, the index rises back to 1,000, this is an increase of 11.11%, and the inverse ETF would fall by 11.11%, from $44 to $39.11 [$44 × (1 – 0.1111)]. Over the two-day period, the index value started and ended at the same value, yet the ETF’s value fell 2.22%.

As expected, the inverse and leveraged ETFs have the same issues with daily rebalancing—but they are magnified.

These simple examples assume the ETF is exactly following the underlying index in the advertised manner. In reality, fund managers cannot exactly mimic the index, therefore the tracking error must be taken into account (the difference between the index tracked and the actual ETF value). Add fees and expenses, and the returns could be much lower.

You can invest in inverse and leveraged ETFs through the ETF fund sponsor or through your brokerage firm.

Inverse and leveraged ETFs are not suited for most investors. They are highly risky and extremely volatile.

For an investor to consider such investments, they should comprise only a small portion of a well-diversified portfolio.

Inverse and leveraged ETFs are generally geared toward short-term traders rather than long-term, buy-and-hold investors.

The tax implications on these specialty ETFs are complicated and might require the help of a tax professional.

In order to magnify returns, leveraged ETFs might use swaps and futures, which disqualifies ETFs from the traditional in-kind redemption process that has given ETFs a reputation of tax efficiency.

For investors with a high tolerance for risk and volatility, leveraged ETFs are an easy way to gain magnified exposure to the market on a daily basis.

Inverse ETFs allow for investors to bet against the market on a daily basis without having to make complicated trades using short sells, swaps, futures or options.

Inverse and leveraged ETFs are extremely risky. The daily rebalancing means the performance may not be what you would expect. As the examples showed, you may end up losing much more than you bargained for.

Due to the nature of the investments that are made to maintain the advertised structure of the ETF, investors are subject to a different set of tax rules. While plain-vanilla ETFs are known for tax efficiency, inverse and leveraged ETFs may not have that same characteristic.

www.aaii.com

Each year, AAII publishes a Guide to ETFs. You can read this year’s guide by going to www.aaii.com/guides.

The online edition includes performance data on over 1,479 ETFs, including those employing leverage and inverse strategies.

www.investopedia.com

Investopedia is a Web site devoted to defining and explaining financial words and terms. Enter “inverse ETF” and “leveraged ETF” into the search box for articles discussing various aspects of each investment (scroll down past the sponsored links and dictionary terms).

→ Cara Scatizzi is a former associate financial analyst at AAII.

** Paul** from FL posted over 3 years ago:

I have been trading leveraged and inverse leveraged ETFs daily, 2-3 hours a day, with good results. Profit:Loss ratio now at 91%:9%, and 15% for overall performance 2010 to date. While I realize this day trading investment approach is risky, my results seem to me to be very good over 2010. My investments, were they to fail completely, will not impact my financial security.

Can you supply something other than warnings against this investment approach? I would appreciate input beyond my own models and rules, though these are working well so far.

Thank you.

** Scott Sneddon** from CA posted 11 months ago:

Too bad this discussion didn't go anywhere. I've been interested in using the weakness in holding these products as an advantage. For example, if holding UVXY long will result in less return than expected, then why not short it while the market is heading up? This would have worked incredibly well over this past year in particular.

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