Understanding ETFs: How Leveraged, Inverse and Leveraged Inverse ETFs Work
By Hank Beiter, ETP/Options Analyst for Nasdaq
Exchange-traded funds (ETFs) first came to market in the mid 1990s. In the thirty years that followed, the ETF sector experienced immense growth. In 2002, only 102 ETFs were available in the market;1 fast forward 18 years and more than 7,100 funds were trading globally in 2020.2 Just one year later in 2021, ETF assets under management (AUM) reached over $9 trillion—marking another milestone for the investment vehicle. Today, the ETF sector continues to grow in size and breadth, with issuers innovating around new types of product offerings, including new single-stock leveraged and inverse ETFs.
Why were ETFs created?
Many financial experts believe exchange-traded funds to be one of the most beneficial investment vehicles for retail investors over the last few decades. Before ETFs existed, many retail investors relied on mutual funds to gain exposure to financial markets. However, mutual funds came with their own drawbacks. First, mutual funds could only be purchased at the end of each trading day based on a calculated net asset value (NAV). Second, mutual funds often came with sizable minimum investment requirements and contained relatively high fees and expenses. ETFs came to market and offered many of the same benefits as mutual funds without these drawbacks. ETFs are able to be traded intraday at their current price, just like stocks. Additionally, similar to stocks, the minimum investment requirement is the cost of one share. Due to these benefits ETFs have continued to surge in popularity with both retail and institutional investors.
What is an ETF?
In basic terms, an ETF is a basket of securities that can be traded on a stock exchange through a brokerage firm. ETFs can hold many different type of asset classes—most commonly equities, debt, commodities, and currencies. ETFs are usually distinguished by their investment objective, as well as the type of securities they hold. A few common ETF types include broad market ETFs, sector and industry ETFs, commodity ETFs and actively managed ETFs. The most basic form of an ETF is a market ETF that tracks an underlying index. Typically, indexes are used as a tool to measure the performance of a basket of securities. Index-based funds are also the most traded type of ETF in the market today and track some of the most referenced and well-known indexes such as the S&P 500 and the Dow Jones Industrial Average (DJIA). One of the largest ETFs by AUM tracks the Nasdaq-100 Index™. This ETF trades under the ticker symbol QQQ and has $159 billion in AUM as of July 13, 2022.3
How do ETFs work?
When an ETF issuer decides that they want to create a new fund, they must also determine the fund’s investment objective. For simplicity, let’s assume the issuer decides to create a Nasdaq-100 Index™ ETF. The issuer then decides that they want to create 50,000 new shares of the fund. The issuer goes into the market and purchases the specific names and quantities of the securities which mirror the composition of the Nasdaq-100 Index™. These underlying securities will be held in a trust allowing the issuer to sell shares of their fund. Each share will represent 1/50,000 of the assets of the trust. The price per share will closely reflect 1/50,000 of the sum value of the underlying securities in the ETF trust. This is known as the net asset value (NAV). While ETF prices do not exactly match the NAV of the underlying securities, they generally trade within a tight range of the value.
Once launched, ETF shares can be continuously created or redeemed. This process of creation and redemption is the mechanism that keeps ETF prices aligned with NAVs, and allows ETFs to be more tax efficient, and less expensive than mutual funds. This process is also critical when it comes to helping the fund trade closely to its NAV. The process involves two parties, the ETF issuer creating the fund and an authorized participant or “AP”. The AP will first acquire the securities that the ETF wishes to hold. Using our previous example, if the issuer wishes to create a Nasdaq-100 Index ETF, then the AP would buy shares of each security in the corresponding weights which make up the index. The AP will then deliver those shares to the issuer in exchange for equally valued ETF shares known as a creation unit. This exchange between the ETF issuer and the AP will occur on a 1 to 1 fair value basis. This helps the ETF share price reflect the NAV of the underlying securities.
Leveraged ETFs, Inverse ETFs, and Leveraged Inverse ETFs
“Leveraged” ETFs use debt and financial derivatives to produce amplified returns for investors. While a non-leveraged ETF generally tracks the underlying securities return on a 1:1 basis, leveraged funds can seek to achieve a 1.5:1, 2:1, or even 3:1 ratio of returns.
Investors use “inverse” ETFs as a tool to hedge against risk or generate returns when they speculate that the underlying index or basket of securities will decline in value. This can be viewed similarly to holding short positions on a particular security. As the underlying index or basket of securities declines in value, the Inverse ETF would rise in value. However, if the index or basket rises in value, then the Inverse ETF would lose value. A “leveraged inverse” ETF can be looked at as a combination of the two products. These funds seek to provide a up to – 2X or – 3X return.
Typically, on a given day, an ETF that tracks the Nasdaq-100 Index™ will return 1% when the underlying index returns 1%. With a 3X leveraged ETF, the ETF would generally return 3%, on a day the Nasdaq-100 returns the same 1%. An inverse ETF on the other hand, will produce the opposite returns than that of the funds underlying securities. Using the previous example, when the Nasdaq-100 returns a gain of 1%, an inverse ETF will produce a loss of 1%. If an investor buys a Nasdaq-100 3X leveraged inverse ETF, and during one trading day, the S&P 500 drops by 1%, the investor holding this ETF would achieve a positive 3% return.
Understanding the Risks Associated with Leveraged/Inverse ETFs
The most obvious risk when investing in leveraged ETFs is that your losses—just like your gains—will be multiplied. Say an investor buys a 3X leveraged ETF and the underlying index drops by 1%, our investor just incurred a 3% loss. This same concept applies when investing in inverse leveraged ETFs, but with an opposite effect. If the index gains 1% and the investor holds a 3X leveraged inverse ETF, the investor would lose 3%.
Another very important distinction is that leveraged and inverse funds seek to produce amplified returns on a single trading day and are rebalanced daily to maintain the desired leverage ratio. As a result, returns for periods greater than one day can deviate from the stated leverage ratio. Leveraged and inverse ETFs are complex financial instruments, and investors should know the risks associated before buying these products.
Additionally, leveraged and inverse ETFs may have substantially higher fees than regular ETFs.
These financial instruments can be effective when used correctly by sophisticated investors. However, they can also result in significant losses when implemented erroneously or if they’re not used as short-term trading vehicles.
What is a Single-Stock Leveraged/Inverse ETF?
Another innovative twist on the leveraged and inverse ETFs discussed above is the “single-stock leveraged inverse” ETF. This new type of financial instrument combines elements of traditional stocks, ETFs, and leveraged and/or inverse ETFs. The single-stock leveraged ETF aims to do what its name implies. The fund will use financial derivatives and swap agreements to produce up to a 2X leveraged return correlated to the normal return of the underlying stock. This new type of financial instrument will have three variants: the single-stock leveraged ETF, the single-stock inverse ETF, and the single-stock leveraged inverse ETF. The three variants exist to achieve the same goals as the leveraged ETF, inverse ETF, and leveraged inverse ETF that were discussed in the last paragraph.
The chart below illustrates the potential impact to an investor in these products of a 1% daily stock movement:
| Stock | Inverse ETF | 2X Leveraged ETF | 2X Leveraged Inverse ETF |
|---|---|---|---|
| Gains 1% | Loses 1% | Gains 2% | Loses 2% |
| Loses 1% | Gains 1% | Loses 2% | Gains 2% |
Understanding the Risks Associated with Leveraged/Inverse Single-Stock ETFs
It is important for investors to understand the risks associated with these new financial products. Similar to broad-based leveraged and inverse ETFs, the fund seeks to produce amplified returns on a single day, not on an annual basis. Returns for periods greater than one day can deviate from the stated leverage ratio. Due to this, these products are not designed for long holding periods. Additionally, like broad-based leveraged ETFs, investors buying single-stock leveraged ETFs can expect outsized losses when the market moves in the wrong direction. However, an important distinction is that traditional leveraged ETFs typically track an index made up of a diverse collection of securities. This allows the investor to achieve diversification. When an ETF tracks only one single stock, investors lose the benefit of that diversification. The less diversification that is achieved, generally the riskier the investment is. Due to this, single-stock ETFs are subject to higher volatility than index-based ETFs
To put the differences in risk in perspective, the DIJA recently dropped 2.9% on April 22, 2022, marking one of the index’s worst days of the year. This means a $100 investment in the DIJA 2X leveraged ETF would have lost $5.80. In order to recover the $5.80 loss, the DIJA would need to return roughly 6.15%. On the other hand, for example, Company A stock experienced its worst single day drop of the year on the same day, dropping 25% in a single trading day. This means a $100 investment in Company A single stock 2X leveraged ETF, would have yielded a loss of $50.00. Exactly half of the initial investment. Company A’s stock would need a return of 100% to offset the $50 loss in the ETF.
Given the risks described above, it is important that investors study and understand these new financial products, their risks and consequences before adopting them as part of their investment strategy.
Information is provided for educational purposes only. The content does not attempt to examine all the facts and circumstances which may be relevant to any particular company, industry, strategy or security mentioned herein and nothing contained herein should be construed as legal or investment advice. Nasdaq does not recommend or endorse any securities offering; you are urged to read the company’s SEC filings, undertake your own due diligence and carefully evaluate any companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.
1 Stephen D. Simpson, A Brief History of Exchange-Traded Funds, Investopedia, January 31, 2022, available at: https://www.investopedia.com/articles/exchangetradedfunds/12/brief-history-exchange-traded-funds.asp.
2 Ibid.