Leveraged & Inverse ETFs: Risks and Rewards Explained

What Are Leveraged and Inverse ETFs?

Leveraged ETFs are designed to deliver multiples of the daily returns of an underlying index. Typically, they aim to provide 2x or 3x the performance of an index, meaning if the index gains 1%, a 2x leveraged ETF would gain 2%, and a 3x leveraged ETF would gain 3%. However, this leverage works in both directions, meaning losses are also magnified. These ETFs achieve their leverage using financial derivatives like swaps, futures contracts, and options.

Inverse ETFs, on the other hand, are designed to profit from declines in an underlying index. Unlike traditional ETFs that rise when the market goes up, Inverse ETFs increase in value when the market falls. These ETFs use derivatives such as futures and swaps to achieve their goal. Inverse ETFs are often used by traders as a way to hedge against market downturns without short-selling stocks.

While both types of ETFs use derivatives to achieve their objectives, the key difference lies in their purpose. Leveraged ETFs seek to amplify returns in the same direction as the index, whereas Inverse ETFs aim to generate gains when the index declines. Both are structured to track daily returns, making them less effective for long-term investments.

It is important to note that Leveraged ETFs and Inverse ETFs are not permitted for trading in India as per SEBI regulations. 
 

How Do Leveraged ETFs Work?

To maintain their leverage, Leveraged ETFs rebalance daily. This means they reset their exposure every trading session. While this mechanism ensures that they closely track their intended multiple on a daily basis, over time, compounding can create divergence from expected returns.

Let’s take an example to understand this better. Imagine an investor buys a 2x Leveraged ETF that tracks the S&P 500 index.

On Day 1, the S&P 500 gains 2%, so the ETF should gain 4%.
On Day 2, the S&P 500 drops 2%, so the ETF loses 4%.

While the index’s net change is 0% over two days, the ETF has suffered a small net loss due to daily compounding.
This example highlights why Leveraged ETFs are primarily used for intraday or short-term trading rather than long-term investments.

Advantages & Disadvantages of Leveraged ETFs

How do Inverse ETFs work?

Since Inverse ETFs aim to move in the opposite direction of their underlying index, they are useful for traders who expect short-term market declines. However, due to compounding effects, holding an Inverse ETF over an extended period can lead to unexpected returns. Consider an Inverse ETF that tracks the Nasdaq 100 index.

• On Day 1, the Nasdaq 100 drops 3%, so the ETF gains 3%.
• On Day 2, the Nasdaq 100 gains 3%, so the ETF loses 3%.
• Over two days, while the index is nearly at breakeven, the ETF might end up with a small loss due to daily rebalancing and compounding effects.

Advantages & Disadvantages of Inverse ETFs

Are Leveraged & Inverse ETFs Worth the Risk?

Leveraged ETFs and Inverse ETFs are powerful tools, but like every investment vehicle, they are not suitable for all investors. These ETFs are primarily designed for short-term trading and should be used cautiously due to the risks of amplified losses and compounding effects.

• You may consider investing in these ETFs only if:
• You fully understand how they work and the risks involved.
• You are an active trader looking for short-term opportunities.
• You can monitor and manage your trades daily.
• You are using them as a hedging tool rather than a long-term investment.

For long-term investors, traditional ETFs or index funds are often better choices. However, for those looking to capitalize on market movements in the short run, Leveraged ETFs and Inverse ETFs can be useful if handled correctly. 

Conclusion

Leveraged ETFs and Inverse ETFs offer traders an opportunity to amplify gains or profit from market declines, but they come with significant risks. While they can be valuable for experienced traders, their daily rebalancing, high volatility, and compounding effects make them unsuitable for long-term holding. Before investing, it is crucial to understand their structure and limitations, ensuring they align with your risk tolerance and investment strategy.

This article is for educational purposes only and should not be considered financial advice. Always conduct your own research and consult with a financial professional before making investment decisions.