What are leveraged and inverse ETFs?

At ESKIMO, we believe it is important that you invest with sufficient knowledge and/or experience. Furthermore, we would like to make sure that you trade financial instruments that suit your needs and objectives. This article explains what leveraged and inverse Exchange Traded Funds (ETFs) are and how you can trade them.

Traditional Exchange Traded Funds

Normally, buying a large number of different stocks requires a sizeable budget and would be time-consuming. However, products, such as ETFs, allow for diversification in an efficient and cost-friendly manner. For example, an S&P 500 ETF will track the 500 stocks included in this index. This makes it possible to hold a selection of different financial products with a single purchase. An ETF, also known as a tracker, stands for Exchange Traded Fund. It is a product that follows an index, commodity, bond or composition of products. Unlike some other funds, you can buy or sell ETFs on a stock exchange. The performance of an ETF follows the price movements of the underlying products in the fund. ETFs can be leveraged or non-leveraged.

Non-leveraged versus leveraged ETFs

The performance of a non-leveraged ETF tracks the performance of the underlying. This is often an index. When the index goes up 2% for example, the ETF will most likely also go up by approximately 2%. The price of an ETF is not equal to its value. It is also possible to purchase a leveraged ETF. If an ETF has leverage, it means that you borrow money from the issuing party to invest more in the underlying products than the amount you invest. These leveraged ETFs can be relatively complicated and focus on short-term results. Generally, they are not suitable as long term investments. They can have very high risks and costs involved and are, therefore, less suitable for the beginning investor.

What is an inverse ETF?

Inverse ETFs are often called "short" or "bear" ETFs. They seek to return an inverse result to that of the underlying they track. For example, if the value of the underlying decreases, the value of the inverse ETF increases, and vice versa. They use financial products, such as derivatives, to mimic an inverse result instead of taking a short position in the underlying. As a result, they often may not precisely correlate to the underlying long index.

It is not required to use margin to purchase an inverse ETF. An ETF is, in general, a cash product and investors will need to invest the full cash amount. When investing in an inverse ETF the potential losses are limited, unlike having a short position in an asset, which has unlimited loss potential if the underlying asset continues to increase in value. The potential loss with an inverse (or 'short') ETF is limited to the amount invested in the fund.

What is a leveraged ETF?

A traditional ETF typically tries to follow an underlying index on a one-to-one basis. A leveraged ETF, on the other hand, returns a multiple of the gains or losses of the underlying. They are designed to magnify the performance of the underlying, which is often an index. It may, for example, aim to double or even triple the performance of the underlying. To attain this ratio, a leveraged ETF can use financial derivatives and debt. This magnifying effect goes both ways. With a gain of 1%, a leveraged ETF will reach a gain of 2% or even 3% depending on the ratio. On the other side of the coin, this also goes for a loss of 1%. With a leveraged ETF, this will become a loss of 2% or even 3%. They are therefore high-risk products.

Holding the leveraged ETF for more than one day is likely to result in a return different to an exact multiple of the returns of the underlying. This is due to the compounding effect. In addition, embedded costs of the ETF may also have an impact on returns.

What is a leveraged inverse ETF?

It is also possible to combine these two types of ETFs, creating a leveraged inverse ETF. This type of ETF, also called "ultra-short" ETFs, is designed to magnify the inverse of an index's performance. Same as inverse ETFs, they use financial products, such as derivatives to mimic an inverse result instead of taking a short position in the underlying, with the addition of the leverage effect.

What are the costs of investing in leveraged or inversed ETFs?

As well as any fees charged by your broker, the issuer of the ETF may charge entry, exit and/or ongoing fees. These costs are embedded in the product and will be noted in the Key Information Document (KID) or the Key Investor Information Document (KIID). The embedded costs for leveraged and inverse ETFs can often be higher than those of other ETFs.

What is the risk of investing in ETFs?

Inverse and/or leveraged ETFs can be part of some commonly used investments strategies, but please note that these types of ETFs carry high risk and are usually not suitable for inexperienced investors. It is recommended that you read the KID or KIID thoroughly to ensure you understand the product you are investing in. The KID or KIID will provide key information on the ETF to investors, such as the costs and risks involved and the investment objectives. It will not state what profits (or losses) can be expected from the investment.

The KID or KIID will give essential information regarding the specific ETF, including the risk and return profile.

Investing in ETFs can be beneficial, but it is not without risk. At ESKIMO, we are open and transparent about the risks associated with investing. Typically, ETFs are not actively managed. The risk is that it is not possible to anticipate changes such as company takeovers or a change in the index composition.

Even though ETFs consist of a collection of products and are, therefore, typically diversified by nature, the timing of your investments can have a substantial impact on your returns. Rather than investing a single lump sum at once, thereby exposing yourself to the cost of your securities at a single point in time, you can instead opt to invest gradually over a longer period. By investing in smaller amounts, say on a monthly or quarterly basis, you will be less exposed to the price paid at the time of investment but rather the investment will be averaged out across a longer time frame. This method is known as unit cost averaging. Read more about diversification in this article.

Before you start investing, there are a number of factors important to consider. It helps to determine how much risk you are willing to take on and which products are best for you. In addition, it is not advisable to invest money that you may need in the short term or to take positions that may cause financial difficulties.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.