What to know about leveraged and inverse ETFs

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How much leverage is a good thing?

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When you’re investing, taking risks can bring rewards—or losses. Inverse and leveraged exchange-traded funds (ETFs) are very risky investments that can amplify returns but can compound losses if the markets go against you.

Inverse and leveraged ETFs are niche trading vehicles for short-term trading. They have daily return objectives and, in general, are not for buy-and-hold investors.

Many leveraged, inverse, and leveraged inverse vehicles are not ETFs but rather are exchange-traded notes (ETNs) that often are lumped together with ETFs. ETNs are debt instruments and subject to counterparty risk—the possibility that the other party in an investment or transaction may default on the obligation.

First off, knowing how traditional exchange-traded funds work helps to understand how leveraged and inverse ETFs function. A traditional passive ETF seeks to track the price of an index, such as the S&P 500. The price of the ETF goes up and down at roughly the same pace as the index by owning the same securities as the index. If the Nasdaq 100 goes up 1%, for example, an ETF tracking that index, such as the Invesco QQQ (QQQ), rises by the same percentage.

A leveraged ETF amplifies those gains or losses. These types of ETFs may attempt to create returns that are two, three, or even 10 times the return of an underlying index. Fund companies issuing the leveraged ETF won’t own the underlying securities of the index, but will often use options contracts to amplify the return.

An inverse ETF, sometimes called a short ETF, seeks to profit when the price of a benchmark falls. These ETFs often use futures contracts, swaps, or other derivatives to try to meet the daily return objectives. These can offer short-term portfolio hedges against declines, and are easier to use than creating a margin account for short selling.

A leveraged inverse ETF combines these two strategies into one ETF, seeking to amplify the return when an index drops. These funds are highly speculative.

There are leveraged ETFs and inverse ETFs in most sectors, including:

These ETFs are best used as short-term trading vehicles, not long-term buy-and-hold positions. Although these ETFs have stated objectives, there can be a significant difference between the expected return and actual performance over the long term.

Leveraged ETFs seek to magnify the daily return of an index, whether it’s by two, three, or 10 times (or the inverse). In dollar terms, that means that for each dollar invested the goal is to return $2, $3, or $10 compared to the daily performance of the index.

At the end of each trading day, the most inverse and leveraged ETFs “reset” to that day’s settlement price, and the next day, the ETF seeks a return that corresponds to its leveraged and/or inverse objective.

If a fund is held beyond a day, the return is a compound of daily leveraged returns based on how long the investor owns the fund.

The Securities and Exchange Commission (SEC) uses this example to show how a two-times leveraged fund works on a down day and then on an up day:

Even when the ETF rebounds on the second day, the return is lower than the index because the fund has to recoup its gains from a lower level. The longer an investor holds the fund, the more their leveraged returns deviate from the index’s nominal performance. If you hold it for a day, a leveraged ETF will track the index accordingly. But if you hold it for a week, a month, or year, your return profile can deviate greatly from the weekly, monthly, or annual return of the underlying benchmark due to the “daily reset” nature of these ETFs.

Leveraged and inverse products are designed for trading, not investing. These products might be appropriate for someone who:

If you can’t tolerate losing a lot of money in a short time or don’t understand how these funds operate, they are not for you.

As with any investment, it’s important to know what you own. That involves reading the prospectus to understand how it seeks to achieve its objective and what the risks are. With leveraged and inverse products, the risks are substantial.

Further, these funds are typically much more expensive to hold than other ETFs, and they can be less tax efficient because the daily calculation and reset may cause short-term capital gains, meaning they are taxed at the same level as ordinary income.

This article is intended for educational purposes only and not as an endorsement of a particular financial strategy, company, or fund. Encyclopædia Britannica, Inc., does not provide legal, tax, or investment advice. Please consult your legal or tax advisor before proceeding.