How Inverse and Leveraged ETFs Work: Use Cases, Risks and ETFs to Consider

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Often, the degree of one’s conviction is demonstrated by the actions one is willing to take. Within the realm of investing, Inverse and Leveraged ETFs have risen in popularity as tools by which investors can amplify their conviction regarding the direction of a particular stock, industry, or market in its entirety. However, they come with distinct advantages and significant risks. This paper will provide a brief overview of inverse and leveraged ETFs and the value proposition they provide to investors.

Inverse and Leveraged ETFs Explained

Inverse and Leveraged ETFs aim to provide either a positive or negative multiple of an underlying asset’s performance over a specified time. These investment products employ various complex strategies involving derivatives (primarily futures and swap contracts) and are not designed to be held longer than the reset periods stated in their prospectuses. That means an ETF that aims for a daily multiple shouldn’t be held longer than a single day.

Use Cases of Inverse and Leveraged ETFs

For investors interested in using Inverse and Leveraged ETFs, their value proposition makes them effective for specific use cases.

Inverse ETFs:

Hedging: Inverse ETFs can serve as a hedge against market downturns. Investors can use them to protect their portfolios from declines in the value of certain assets or indexes.

Profit from Declines: These ETFs allow investors to profit from declines in the underlying index or asset without selling short or using derivatives.

No Margin Requirements: Unlike traditional short selling, inverse ETFs do not require margin accounts, reducing the risk of margin calls.

Leverage ETFs:

Magnified Returns: Leveraged ETFs aim to deliver multiples of the performance of the underlying index or asset (e.g., 2x or 3x). This can result in significantly higher returns in a short period if the underlying index moves in the intended direction.

Short-Term Trading: These ETFs are designed for short-term trading and can be useful for day traders looking to capitalize on market movements.

Ease of Use: Leveraged ETFs allow investors to gain leveraged exposure without using margin accounts or engaging in complex trading strategies like options or futures.

Cost Efficiency: Compared to creating a leveraged position using margin or derivatives, leveraged ETFs can be more cost-efficient for short-term trades.

Leveraged Inverse ETFs:

An ETF can be both leveraged and inverse, meaning it can magnify losses and target gains when the underlying asset price falls, with a -2x ETF aiming to double the daily inverse return.

Considerations when using Inverse and Leverage ETFs

Due to the amplified performance provided by Inverse and Leveraged ETFs, investors need to be cognizant of the risks associated with these products and their substantial loss potential over a short period of time. Though the risk associated with levering up or shorting is familiar to most investors, the compounding effect is a unique risk to Inverse and Leveraged ETFs.

Since these products deliver multiple of their underlying benchmark returns daily, they must reset the amount of leveraged or inverse exposure they have each day. This daily reset means the products will not always deliver their expected multiple. As the markets generally display volatility to the upside and the downside, the daily resetting of these products will cause the products to perform worse than their multiple would suggest over a longer than one day.

Thus, it is extremely important to understand that when holding for longer than a day, these products may not give you the returns you may be expecting.

Accessing Inverse and Leveraged ETFs

For Canadian Investors interested in Inverse and Leveraged ETFs, Global X Canada and Hamilton ETFs are ETF manufacturers that have these investment solutions within their product line-up.

Global X Canada’s Beta Pro ETF offerings provide daily leveraged (up to 2x), inverse (-1x) and inverse leveraged (up to -2x) exposure across a variety of indices, sectors, asset classes and commodities. Their suite of BetaPro ETFs is designed for investors seeking short-term, tactical trading vehicles and are comfortable managing investments with greater risk potential. Currently, there are 21 fund offerings under this fund family.

Hamilton ETFs currently has three leveraged ETF offerings, each specifically focusing on a Canadian sector. The ETFs are:

Hamilton Enhanced Utilities ETF (Ticker: HUTS) will replicate a 1.25x multiple of a rules-based utilities index, currently the Solactive Canadian Utility Services High Dividend Index TR.

Hamilton Enhanced Canadian Bank ETF (Ticker: HCAL) is designed to track 1.25x the returns of the

Solactive Equal Weight Canada Banks Index, investing in Canada’s Big Six Banks.

Hamilton Enhanced Canadian Financials ETF (Ticker: HFIN) will replicate a 1.25x multiple of the Solactive Canadian Financials Equal-Weight Index TR, which consists of equal-weightings of the top 12 largest Canadian financial services companies.

Takeaway

For investors who have an informed understanding of where they believe a sector or the market may be heading, Inverse and Leveraged ETFs are powerful solutions for executing their trading strategy. However, it’s important to note that Inverse and Leveraged ETFs come with significant risks, including the potential for large losses, especially if held over longer periods due to compounding effects. They are typically not suitable for long-term investing and should be used with caution and a clear understanding of their mechanics.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.