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The Lowdown on Leveraged and Inverse Exchange-Traded Products

By Alert Investor - Dec 8, 2016 at 5:46PM

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These instruments are complex and sometimes extraordinarily risky.

Image source: Getty Images.

Exchange-traded products (ETPs), including exchange-traded funds (ETFs) and exchange-traded notes (ETNs), have surged in popularity over the last few years, with more than 1,900 different options. But as the number of these products soars, it's important to remember that not all ETPs carry the same risks.

Since the launch of the first U.S.-based exchange-traded fund in 1993, the number of ETPs in the U.S. has ballooned, with the more than 1,900 different products now representing more than $2.4 trillion of assets, according to data from ETF.com. And now, about one in eight ETPs offers leveraged or inverse exposure.

The thing is, leveraged and inverse (sometimes referred to as "geared" or "non-traditional") products don't work the same way as your average ETF or ETN, and they have a whole host of unique risks. These are complex investments, and it's important that investors understand these products before they invest.

So let's take a step back and look at just what we are talking about.

An inverse ETP generally seeks to deliver the opposite of the performance of a given index over a given time period. Meanwhile, a leveraged ETP generally seeks to deliver multiples of the performance of an index over a given time period. A leveraged inverse ETP, meanwhile, seeks to deliver a multiple of the opposite of a given index's performance over some time period.

Most geared ETPs "reset" every day, which means they are only designed to accomplish the stated leveraged or inverse objective on a daily basis. These ETPs don't make any promises as to how their returns will compare over a longer period, which can make the products risky long-term -- or even medium-term -- investments.

For instance, a daily inverse ETP pegged to the S&P 500 will try to deliver a return that is exactly the opposite of what the index delivers in a given day. If the S&P 500 closes up 1.5%, then the inverse ETP would aim to close down 1.5%, and vice versa.

Meanwhile, a daily leveraged ETP pegged to the S&P 500 may set its multiple at two, which is often expressed in a product's name as "2x." That means this ETP will aim to deliver twice the return (or twice the loss) of the S&P 500 on a given day. If the S&P 500 gains 5% in a day, then investors in the leveraged ETP described above would see gains of 10%.

And a daily leveraged inverse ETP pegged to the S&P 500 may set its multiple at negative two, meaning that if the S&P 500 falls on a given day, investors in the ETP will see gains equivalent to twice the index's percentage loss. So if the S&P 500 gains 5% in a day, then investors would see losses of about 10%.

Sound complicated? That's because it is. To achieve these stated returns, leveraged and inverse ETPs often use a range of investment strategies, including swaps, futures, and other derivatives.

And because each ETP has its own investment strategies and goals, no two are exactly alike.

"These are generally speculative tools," said Dave Nadig, the director of Exchange Traded Funds for the financial research firm FactSet.

"Because of the way compounding math works, if you hold [an inverse or leveraged ETP] for a month, your return over the course of a month isn't going to be exactly two times the return of S&P 500," Nadig said.

Here's an example to help break it down. Let's say on day one you have one $100 share of a 2x ETP. Let's say that, like the ETP, the index starts at 100. On the second day, the index drops 10% to 90, resulting in a 20% loss for the ETP, bringing its value down to $80. Then, on the third day, the index jumps 10% to 99, resulting in a gain of 20% for the ETP. However, 20% of $80 is just $16, meaning the ETP is now at $96.

On both days, the ETP achieved its stated objective and produced daily returns that were two times the daily index returns. But at the end of three days, the index lost just 1%, while the 2x leveraged ETP lost 4%. That means that over just a couple of days, the ETP lost four times as much as the index, not just two times. (This is not "tracking error," however, since the ETP met its daily objective.)

"It takes more money to get back from a loss," Nadig said. "If you're trying to get two times the return of the S&P 500 for a year, this is not how you do it."

On top of that, leveraged and inverse ETPs may be more costly than a traditional ETP in terms of both fees and the tax consequences, in part because daily resets make it more likely that an investor would hold the shares for a short amount of time and therefore fall into the short-term capital gains tax bucket.

High fees on any investment can erode returns. It's a good idea to check out FINRA's Fund Analyzer to estimate the impact of fees and expenses on your investment.

But the bottom line is that not all ETPs come with the same risk. The products are all called exchange-traded products, Nadig said, "but that doesn't necessarily mean that they're for everybody."

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