What it means
An ETF holds a basket of assets and trades through the day on an exchange. Many ETFs simply track an index, such as a broad share market index, but some providers also offer funds with a more specific goal.
ProShares is best known for funds that seek to provide, for example, twice the daily return of an index or the reverse of its daily return. The important word is daily.
A leveraged or inverse ETF resets its exposure each day, so over periods longer than one day the return does not simply equal the stated multiple of the index's return. In volatile markets this compounding effect can cause results to drift well away from what many investors expect.
These funds are typically used by active traders to express a short-term view or to hedge a position for a day or two. Fund documents carry prominent warnings that they are not intended for investors who plan to hold them for long periods without monitoring, and the cost of borrowing and fund expenses also reduces returns.
Beyond leveraged and inverse products, the same firm and others sponsor conventional ETFs covering sectors, income strategies and other themes. As with any fund family, the right approach is to judge each fund on its own prospectus, covering its objective, fees, holdings and risks.
For a business or finance professional, the main lesson is to understand the mechanics before using such products. Treasury and finance teams should be especially careful, because a complex fund may look like a simple hedge while behaving very differently over a month.
In practice
Real-world examples.
Example
A trader expects bad news from a company to hit the market tomorrow. She buys $5,000 of an inverse fund for one day, aiming to gain if the market falls, and sells at the close.
Example
A portfolio manager with a $2,000,000 share portfolio wants a temporary hedge over a risky week. He buys a small amount of an inverse ETF, and sells it as soon as the event has passed.
Example
A retail investor buys a 2x leveraged fund and holds it for a year, expecting to make exactly twice the index return. The index ends the year up 10%, but because of volatility and fees the fund gains only 12%, and he is surprised it is not 20%.
Formula
Calculation
The effect of daily resetting on a leveraged fund can be shown by compounding the daily returns:
Fund value after two days = Starting value x (1 + 2 x Day 1 index return) x (1 + 2 x Day 2 index return)
Suppose a fund aims to deliver twice the daily return of an index. An investor puts in $10,000. On day 1 the index rises 10%, and on day 2 it falls 10%.
The index itself moves 1.10 x 0.90 = 0.99, a loss of 1% over the two days.
The 2x fund gains 20% on day 1, so $10,000 x 1.20 = $12,000. It then falls 20% on day 2, so $12,000 x 0.80 = $9,600.
The fund lost 4%, which is four times the index's 1% loss and not the 2% a simple doubling would suggest, even though before fees the index ended close to where it started.Case study
Seen in the real world.
Larchmont Advisory is an illustrative, fictional wealth firm whose junior analyst proposed holding a leveraged index fund as a core long-term holding. The analyst's logic was that if the index rose 8% a year, a 2x fund would earn 16%.
The head of research asked him to model the fund over a volatile two-year period using daily returns. The model showed that the index finished roughly flat while the 2x fund lost around 9%, because of the effect of daily resetting and a series of swings.
The firm decided to use such funds only for short-term, monitored positions and wrote this into its investment policy. The illustrative lesson is that leveraged and inverse funds do exactly what they say, which is to target a multiple of the daily return and not of the long-term return.
Watch out
Common mistakes.
- Holding a leveraged or inverse fund for months and expecting it to deliver the stated multiple of the index's return over that period.
- Treating all funds from the same sponsor as having the same risk, when conventional and leveraged funds are very different.
- Overlooking fees and financing costs, which reduce returns and are higher in complex funds than in simple index funds.
Questions
People also ask.
What does a 2x leveraged ETF do?
It aims to deliver twice the return of its index each day, using derivatives and borrowing, and so it gains and loses faster than the index.
What is an inverse ETF?
It aims to deliver the opposite of an index's daily return, so it rises on days when the index falls, which makes it useful for short-term hedging but risky to hold for long.
Are these funds suitable for everyone?
No, they are complex products intended for experienced investors who understand the risks and monitor positions often, and anyone unsure should seek independent advice.
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