Be Careful of Leveraged and Inverse ETFs

Leveraged and inverse ETFs have in recent months come to the attention of US Regulators regarding their suitability as long term investments for retail investors.

Just to recap, leveraged ETFs aim to double or triple the performance of an underlying benchmark, while inverse ETFs move in the opposite direction to their benchmark.

In theory, that is.

ProShares is one of the largest issuer of leveraged and short ETFs. The leveraged ones are easily identifiable by the word Ultra in front of the name while the inverse will have the word Short. There are also ETFs that are both leveraged and inverse. These will have the word Ultrashort.

The ProShares list of ETFs can be found here.

In reality, these ETFs may not always move in the direction that investors expect. If held for a longer term, some of these ETFs can lose big even when an investment in the underlying benchmark would have gained due to how the ETFs are structured.

For example, it was recorded that an ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index actually fell around 50 percent while the index gained around 8 percent. The related ETF seeking to deliver three times the inverse of the index’s daily return declined by 90 percent over the same period.

In June, Financial Industry Regulatory Authority, the industry’s self-regulating body, issued a warning indicating leveraged ETFs as unsuitable for retail investors for more than one trading session. It later amended the warnings to say that the ETFs can be appropriate for short-term investors under close supervision of financial professionals.

In mid July, Massachusetts regulators subpoenaed Ameriprise, UBS, LPL, among others, to produce information on revenues, sales, broker training and marketing materials related to these products.

ProShare Advisors said its ProShares funds “have performed consistent with their daily investment objectives as fully described in the prospectus,” in a statement responding to Massachusetts officials’ inquiries last month.

Still, several major brokerage houses have already stopped or suspended sales of these instruments for the time being.

In a nutshell, while inverse and leveraged ETFs may give you the desired exposure you want over the short-term, they are definitely not suitable as long term investments.

In Singapore, the only leveraged or inverse ETF that is listed so far is DBXT S&P Short 10US$. It is an inverse ETF based on the S&P Index.

Of course, you can access the whole range of ETFs by buying from the overseas market.

Trade with care!

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4 comments

Newbie says 14 years ago

I always thought that that the normal [not inverse or leverage] ETF of STI consists of a portfolio of stock in smaller size that make up the STI index so that the performance of this portfolio will strictly mimic the movement of the index.

An ex-future trader friend of mine said that this is not so because STI index is copyrighted and what the ETF producer does is construct a porfolio of stock that mimic the STI index but they are not the actual component stock that make up STI index. The ETF producer is selecting the stock that move in closely with the STI component stock. After the ETF is launched, the ETF performance may not be the same as the Index movement.

Can anyone confirm that is this true?

lioninvestor says 14 years ago

Hi Newbie,

Some ETFs are swap-based in nature. These are synthetically created to track the index.

The issue will select a basket of stocks that will closely mimic the underlying index.

Obviously, there will be a slight difference in performance. This is the tracking error.

So, what the ETF does is to enter into a swap arrangement with a swap counterparty.

The swap counterparty will “take” the performance of the basket of stocks, and give the ETF the return of the underlying index.

Basically, what this means is that if the basket of stocks does better than the index, the outperformance will be paid to the swap counterparty. Conversely, if the basket of stocks underperform the index, the swap counterparty will have to make up the difference.

A number of the ETFs listed on our market are swap based in nature. The swap counterparty in most cases is the creator of the ETF or an entity affiliated to the creator.

VSL says 14 years ago

I am deeply concerned with the way new ETFs are structured and sold. When ETFs were started several yrs ago, their intentions and objectives were good, viz to track a reliable and trustworthy index.

What the heck are we having now. Leveraged ETF, Inverse ETF, ETF that invests in ETFs etc. Very soon FIs may start selling risky structured notes disguised as ETFs.

I am afraid many unsuspecting retail investors may fall into a similar trap like what happened in 2008 with the Global Financial Crisis. This is because ETFs have previously been touted as generally safe investments, but ordinary investors may not understand the different versions of ETFs now being introduced. And MAS seems to be doing nothing about it.

lioninvestor says 14 years ago

Hi VSL,

to be fair, other than DBXT S&P Short 10US$, we don’t have any of those inverse or leveraged ETFs listed here yet.

But investors do need to know the difference between cash based and swap based ETFs.

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Be Careful of Leveraged and Inverse ETFs

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