Introduction to Leveraged and Inverse ETFs

Jack is a conservative investor who understands the market. He builds his portfolio to prepare for retirement. Jack mainly follows a buy-and-hold strategy, is unwilling to take on too much risk, and does not review his portfolio every day. He cares more about long-term results and typically measures his portfolio’s performance on an annual basis.

By contrast, Jill is a more active investor. Rather than calling her an investor, it might be more accurate to call her a frequent trader. Jill has years of investing experience and likes to look for short-term trading opportunities in the market to try to boost returns. She usually builds her strategy around daily or weekly time frames. Jill knows ETFs well and is willing to take on higher risk in pursuit of potentially greater short-term gains.

As a conservative investor, Jack holds a U.S. large-cap ETF in his retirement portfolio. These ETFs hold securities and stocks designed to replicate the performance of a U.S. large-cap index. He invested $100, and over the following year the index rose 5%, which means the corresponding ETF he bought also rose 5%. Jack was pleased to see his principal grow from $100 to $105. At that point, he might review his allocation to see whether any rebalancing is needed. Jack is not an active investor and does not want to hold leveraged or inverse ETFs.

After conducting in-depth market research, Jill concluded that the market could rise sharply today. Because she is willing to take on greater risk, she decided to use a leveraged ETF to increase her market exposure. Jill understands that leveraged ETFs differ from unleveraged ETFs in two main ways: they use leverage and they seek daily investment returns. Like the ETF Jack holds, these products are mainly built around stocks and aim to replicate the gains or losses of the index they track. But the leveraged ETF Jill holds also includes derivatives — usually futures contracts and total return swap agreements — to target two or three times the daily return of a comparable unleveraged ETF.

For example, Jill bought $100 of a daily 3x leveraged ETF because she believed the index would rise during that trading day. The ETF she bought uses 3x leverage, giving her 300% exposure to the tracked index, or three times the index’s daily move. For Jill, her one-day index exposure was effectively $300.

As Jill expected, the market rose. The index gained 1% for the day, so her leveraged ETF returned three times the index’s daily gain — in other words, it rose 3%. Her initial $100 investment became $103. However, if Jill had been wrong about the market and the index had fallen 1% for the day, she would have lost 3%, or three times the index’s daily loss. Her original $100 would have been reduced to $97.

That is why investing in leveraged or inverse ETFs involves risk — they can be powerful tools that amplify returns, but they can also increase risk.

Having covered leverage, let’s turn to daily returns. Jack’s goal in investing in ETFs is long-term investing. Buying a plain index-tracking ETF saves him the trouble of constantly monitoring his portfolio. But when Jill buys a 3x leveraged ETF, she clearly understands that its objective is to seek 300% of the index’s return for that single day only. She knows that leveraged ETFs track only the benchmark index’s daily return. If she holds a leveraged ETF for more than one day, the ETF’s cumulative gain or loss may be significantly higher or lower than 300% of the index’s cumulative gain or loss over the same holding period. That is because daily rebalancing and compounding will affect the performance of leveraged and inverse ETFs. If you want to trade leveraged and inverse ETFs like Jill, you need to fully understand daily rebalancing and compounding effects. We will explain this in detail in the next chapter.

As a professional investor, Jill is very familiar with Direxion’s ETF lineup, which falls into two main categories: leveraged (long) ETFs and inverse (short) ETFs. As their names suggest, leveraged and inverse ETFs give professional investors like Jill the potential to profit in both bull and bear markets.

For example, if the market trend is downward, Jill might buy a 3x inverse ETF to gain short exposure to the market. An inverse ETF is designed to seek the inverse of the target index’s daily return at 3x, or -300%. In other words, Jill would have $300 of inverse exposure. If the index falls 1% in a day, the inverse ETF would rise 3% for the day; if the index rises 1% in a day, the inverse ETF would fall 3% for the day.

For prospective investors, our recommendation is this: before investing in any leveraged or inverse ETFs, consult a professional investment advisor.