Understanding leveraged and inverse ETFs

10 May 2022 by Horizons ETFs Management
A man places a wood chip on a pile.

For self-directed investors, the idea of buying leveraged Exchange Traded Funds (ETFs) can be enticing, as they can provide potentially better returns over a shorter period of time versus traditional ETFs.  

Of course, with the opportunity to generate higher returns comes higher risk, and it’s extremely important that investors understand the specific risks of leveraged and inverse leveraged ETFs in assessing whether they are an appropriate investment for them. Let’s take a look at this class of ETFs and find out what’s important to consider before potentially incorporating them into your investment portfolio.

1. What are leveraged and inverse leveraged ETFs? 

Leveraged and inverse leveraged ETFs are a subset of Exchange Traded Funds that typically use financial derivatives aiming to amplify the returns on an underlying index or asset class. 

For instance, while a traditional index ETF may seek to match the returns of a benchmark index, like the S&P/TSX 60™, a leveraged ETF could seek to deliver up to multiple-times the daily performance of that index. In the case of inverse leveraged ETFs, the investment objective may be to generate a potential profit from negative performance on a given index, so if the index were to fall, the ETF would potentially see a gain.

Typically, these ETFs are used by high-conviction investors with a short-term trading horizon, looking to utilize a higher-risk profile to generate potentially higher short-term returns. 

Another feature: unlike leverage achieved through margin accounts or options trading, the risk of losses is limited to the principal investment, when using these ETFs. 

Another feature: unlike leverage achieved through margin accounts or options trading where the risk could result in losses greater than the initial investment for the investor. When using these ETFs, the risk of losses is limited to the principal investment. However, in order to maintain this, the ETFs exposure typically needs to be reset on a daily basis to manage that risk.

In Canada, leveraged and inverse leveraged ETFs are predominantly offered through Horizons ETFs’ BetaPro line-up of ETFs. These ETFs provide a wide range of exposure from equity indices, such as the S&P 500®, S&P/TSX 60™, and NASDAQ-100® to futures-based strategies that invest in commodities like oil and gas. South of the border, there are several fund providers that offer leveraged and inverse leveraged ETFs on U.S.-listed exchanges with returns that can be up to 3x or -3X of its underlying exposure.

2. Can you hold these ETFs for more than one day? 

Leveraged and inverse leveraged ETFs typically require their exposure to be reset by the ETF manager on a daily basis. Because of this daily reset, the return of the ETF is not expected to match the performance of the reference commodity, benchmark or index for periods longer than one day. 

Compounding can also impact returns as well. Compounding is the reinvestment of earnings from an investment back into the original investment, which is then subject to the full earnings and price fluctuations of that investment. It can potentially result in a larger annual return in a rising market, or averaging cost down in a declining market.

So if you plan to hold these ETFs for more than one day, even while correlated, the actual returns will likely be different than the anticipated returns over an observed period.

The simplified hypothetical examples below using a BetaPro Daily Bull ETF (with full 2x exposure), a BetaPro Daily Bear ETF (with full -2x exposure) and a Horizons Daily Inverse ETF (-1x) in different markets, show potential effects of compounding as a result of daily rebalancing.

Simplified hypothetical examples

It’s crucial to understand that, if an investor is going to hold a leveraged (or inverse leveraged) ETF for more than one day, then they should closely monitor that the ETF is providing exposure that matches the original intent of owning the investment. 

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3. How Volatile are leveraged and inverse leveraged ETFs? 

All leveraged and inverse leveraged ETFs are inherently riskier and potentially more volatile than a single-long ETF that invests in the same universe of securities, since they are highly speculative and use leverage that magnifies returns and losses.  

The volatility of these ETFs is also impacted by the underlying investment. For example, a leveraged ETF that has natural gas futures as its underlying exposure is going to be significantly more volatile than a leveraged ETF that invests in large-cap Canadian equities due to the fact that Natural Gas futures, even without leverage, tend to be quite volatile. 

In general, leveraged commodity ETFs would be expected to have higher volatility than traditional equities. Volatility is also important to note because it can impact the anticipated direction of the ETF. The more volatile the asset class the more we would anticipate that the performance of the ETF, beyond one day, may deviate more from its benchmark due to the daily resetting of the exposure. 

4. Do leveraged or inverse leveraged ETFs invest in futures? 

Asset classes, such as crude oil, require the ETF to invest in futures. 

What are futures? Futures are contracts with uniform terms and maturity dates – typically involving specific asset classes and commodities – and require parties to exchange money for the asset at a specified time in the future. 

Instead of settling on the specified time in the future, ETFs that use futures typically roll from their specified delivery month to a subsequent delivery month before contract maturity (when the holder of the contract would be required to accept or make delivery of a physical commodity). Because of this function, investors should pay special attention to something we refer to as the futures curve.

Typically, the futures an ETF hold either roll into a contract that is at a higher price (where the futures curve is in “contango”) in which the futures holder will pay a premium to roll into the next contract. Conversely, there are periods where the futures contracts will be rolled into a contract at a lower price (where the futures curve is in “backwardation”) where the ETF would then earn money from rolling into the lower cost contracts.  

When you add leverage to these scenarios, it creates leverage on these roll premiums or discounts. For example, if the price of oil is range-bound for an extended period of time, but the futures are in contango, and investor who buys a 2x Daily Bull ETF will likely lose money from paying two-times the roll premium. On the other hand, an investor on the short-side of the trade with a -2X Daily Bear ETF, would be expected to generate a positive return from earning 2x the roll premium over that period - assuming that all other things were equal, and the market return of oil didn’t move.  

Futures Curve in Contango

Futures Curve in Contango

Futures Curve in Backwardation  

Futures Curve in Backwardation

Leverage on futures then means that it is not good enough to get the directional call on the asset class right, the investor also has to factor in the cost of future roll costs if the ETF is being held over a multiple-day period. 

5. Do these ETFs meet your risk/return objectives? 

Too often, self-directed investors use a leveraged or inverse leveraged ETF as a position in their core-portfolio instead of simply buying and holding a non-leveraged ETF. This can be a very risky proposition due to the high risk associated with investing in these ETFs.  Leveraged and inverse leveraged ETFs are speculative investments where an investor should have high conviction on the direction of the investment with the ability to monitor and adjust their positions on a frequent basis. This means these ETFs are generally more appropriate for experienced investors who have the ability to speculate on asset classes with a clear understanding that their losses can be significant if they are wrong. 

For investors that don’t fit this criteria, despite the tantalizing returns that can sometimes be generated by these ETFs, it doesn’t necessarily make them an appropriate investment. 

Think of it as using an F-1 racing car to drive to the grocery store. The F-1 car can go extremely fast but it’s not entirely practical (or safe) for this purpose. If your goals are simple investment goals of being a long-term investor who doesn’t want to be frequently changing their allocation to meet their return objectives, simple long-only index ETFs are likely more appropriate. 

Understanding your risk tolerance and objectives will go a long way in determining whether leveraged and inverse leveraged ETFs are a type of investing you are comfortable in engaging in.  

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Views expressed in this article are those of the author, Horizons ETFs. They do not necessarily reflect the opinions of NBDB.

Commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by Horizons ETFs Management (Canada) Inc. (the "Horizons Exchange Traded Products"). The Horizons Exchange Traded Products are not guaranteed, their value changes frequently and past performance may not be repeated. Certain Horizons Exchange Traded Products may have exposure to leveraged investment techniques that magnify gains and losses and which may result in greater volatility in value and could be subject to aggressive investment risk and price volatility risk. Such risks are described in the prospectus. The prospectus contains important detailed information about the ETF. Please read the relevant prospectus before investing.

The BetaPro Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the BetaPro Products. Please read the prospectus before investing.

The Horizons Exchange Traded Products include our BetaPro products (the “BetaPro Products”). The BetaPro Products are alternative mutual funds within the meaning of National Instrument 81-102 Investment Funds, and are permitted to use strategies generally prohibited by conventional mutual funds: the ability to invest more than 10% of their net asset value in securities of a single issuer, to employ leverage, and engage in short selling to a greater extent than is permitted in conventional mutual funds. While these strategies will only be used in accordance with the investment objectives and strategies of the BetaPro Products, during certain market conditions they may accelerate the risk that an investment in shares of a BetaPro Product decreases in value.

The BetaPro Products consist of our Daily Bull and Daily Bear ETFs (“Leveraged and Inverse Leveraged ETFs”), Inverse ETFs (“Inverse ETFs”) and our BetaPro S&P 500 VIX Short-Term Futures™ ETF (the “VIX ETF”). Included in the Leveraged and Inverse Leveraged ETFs and the Inverse ETFs are the BetaPro Marijuana Companies 2x Daily Bull ETF (“HMJU”) and BetaPro Marijuana Companies Inverse ETF (“HMJI”), which track the North American MOC Marijuana Index (NTR) and North American MOC Marijuana Index (TR), respectively. The Leveraged and Inverse Leveraged ETFs and certain other BetaPro Products use leveraged investment techniques that can magnify gains and losses and may result in greater volatility of returns. These BetaPro Products are subject to leverage risk and may be subject to aggressive investment risk and price volatility risk, among other risks, which are described in their respective prospectuses. Each Leveraged and Inverse Leveraged ETF seeks a return, before fees and expenses, that is either up to, or equal to, either 200% or –200% of the performance of a specified underlying index, commodity futures index or benchmark (the “Target”) for a single day. Each Inverse ETF seeks a return that is –100% of the performance of its Target. Due to the compounding of daily returns a Leveraged and Inverse Leveraged ETF’s or Inverse ETF’s returns over periods other than one day will likely differ in amount and, particularly in the case of the Leveraged and Inverse Leveraged ETFs, possibly direction from the performance of their respective Target(s) for the same period. For certain Leveraged and Inverse Leveraged ETFs that seek up to 200% or up to or -200% leveraged exposure, the Manager anticipates, under normal market conditions, managing the leverage ratio as close to two times (200%) as practicable however, the Manager may, at its sole discretion, change the leverage ratio based on its assessment of the current market conditions and negotiations with the respective ETF’s counterparties at that time. Hedging costs charged to BetaPro Products reduce the value of the forward price payable to that ETF. Due to the high cost of borrowing the securities of marijuana companies in particular, the hedging costs charged to HMJI are expected to be material and are expected to materially reduce the returns of HMJI to shareholders and materially impair the ability of HMJI to meet its investment objectives. Currently, the manager expects the hedging costs to be charged to HMJI and borne by shareholders will be between 10.00% and 45.00% per annum of the aggregate notional exposure of HMJI’s forward documents. The hedging costs may increase above this range. The manager publishes on its website, the updated monthly fixed hedging cost for HMJI for the upcoming month as negotiated with the counterparty to the forward documents, based on the then current market conditions. The VIX ETF, which is a 1x ETF, as described in the prospectus, is a speculative investment tool that is not a conventional investment. The VIX ETF’s Target is highly volatile.

As a result, the VIX ETF is not intended as a stand-alone long-term investment. Historically, the VIX ETF’s Target has tended to revert to a historical mean. As a result, the performance of the VIX ETF’s Target is expected to be negative over the longer term and neither the VIX ETF nor its target is expected to have positive long-term performance. BetaPro Bitcoin ETF (“HBIT”), and BetaPro Inverse Bitcoin ETF (“BITI”), which are a 1X ETF, and an up to -1X ETF, respectively, as described in the prospectus, are speculative investment tools that are not conventional investments. Their Target, an index which replicates exposure to rolling Bitcoin Futures and not the spot price of Bitcoin, is highly volatile. As a result, neither ETF is intended as a stand-alone investment. There are inherent risks associated with products linked to crypto-assets, including Bitcoin Futures. While Bitcoin Futures are traded on a regulated exchange and cleared by regulated central counterparties, direct or indirect exposure to the high level of risk of Bitcoin Futures will not be suitable for all types of investors. An investment in any of the BetaPro Products is not intended as a complete investment program and is appropriate only for investors who have the capacity to absorb a loss of some or all of their investment. Please read the full risk disclosure in the prospectus before investing. Investors should monitor their holdings in BetaPro Products and their performance at least as frequently as daily to ensure such investment(s) remain consistent with their investment strategies.

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