If you are a young investor getting your daily dose of finance on social media apps like Tik Tok and Discord, plugs for inverse and leveraged exchange-traded funds or ETFs have bombarded your feed.
The inverse and leveraged ETFs deliver negative and positive multiples of their underlying index’s performance, respectively. And market enthusiasts have been touting these products on social media as a tool to lock in gains amid Federal Reserve rate hikes that led to market declines in 2022.
Know what you’re getting into before you buy one. These volatile ETFs, particularly the ones with leverage, can quickly pile up huge losses in the wrong market.
Consider an aggressive inverse ETF such as the ProShares UltraPro Short QQQ (ticker: SQQQ), which offers three times the daily inverse of the Nasdaq and gained 82% last year when tech companies bled. The ETF also lost 61% in 2021 and 86% in 2020 as tech companies capped a long bull run. On a 10-year annualized basis, the ETF has lost 51% a year.
The risks aren’t scaring investors for now. Equity-based inverse and leveraged ETFs saw net flows of $27.37 billion in 2022, the highest level in the history of these products, according to Morningstar data. Net flow is the difference between cash into and out of a fund.
Last year 40 inverse and leveraged launched in the U.S. within the equity, debt, and commodity world, the highest level seen since 2011. At least four were launched this year with more to come.
There’s a “desire for an increased number of ways to participate in declines,” Ken South, registered financial advisor and CEO of Tower 68 told Barron’s. That has motivated the industry to create more of these ETFs, he added.
Employing these tools to hedge the shorter-term declines in the value of your investment can make sense in certain circumstances for experienced investors; South uses them occasionally in client portfolios. But high fees and expenses combined with inherent risks of ‘daily rebalancing’ associated with these so-called geared ETFs make them risky long-term—or even medium-term—bets for investors, who aren’t regularly tuning their portfolios and aren’t comfortable handling aggressive risks.
Consider one of many Direxion’s leveraged ETF lineups. The company explains its products by showcasing an enthusiastic trader on a roller coaster buying ETFs, but let’s crunch some numbers on Direxion Daily Energy Bull 2X Shares (ERX) as an example. If you own $100 worth of shares of this ETF and its underlying index Energy Select Sector Index (IXETR) loses 10% at the close of day one of trading, the ETF would be down 20% at $80.
But if the index on day two rises up 10% to close at 99, the ETF would be up by 20% of $80 or at $96. It would achieve its stated objective of two times daily returns on both days, but the leveraged ETF would lose 4% overall as opposed to the 1% loss in the index, making longer-period returns particularly volatile.
“This is really counterintuitive, and it’s hard to grasp,” Elisabeth Kashner, director of ETF research at FactSet said. “They require a lot of investment education [and] are hard to use over a multiday period,” she added.
Besides understanding the underlying risks and having a strong conviction on the direction of the index, investors must also note the high costs. Investors pay an average of 1.02% in fees and expenses for leveraged and inverse products, much more than the 0.61% on average charged by thematic ETFs and 0.095% on an SPDR S&P 500 ETF (SPY). Expense ratios eat into investor returns, and investors may want to use FINRA’s Fund Analyzer to estimate the impact of expenses on their investment.
Matthew Tuttle of Tuttle Capital Management, who last month filed for the Tuttle Capital 2X DBMF ETF, which tracks the daily performance of the iMGP DBi Managed Futures Strategy ETF (DBMF) sees the management fee of 0.85% charged by his fund as appropriate. That’s because it is offering two times the exposure for the same price charged by iMGP’s product, he said. Tuttle launched the Inverse Cramer ETF (SJIM) on Thursday, following the creation of the hugely popular AXS Short Innovation Daily ETF (SARK).
ProShares and Direxion, which dominate the inverse and leveraged ETF universe, state in their prospectus as well as on their website that the funds aren’t suitable for all investors and are not recommended for buy-and-hold investors. Both companies also have a tab dedicated to investor education.
Tuttle puts the onus on investors. “I am a HUGE believer that investors need to be educated about finances, whether they delegate or not,” he said in an email. “At the end of the day these are among many tools for investors to express their views…but more tools require more work on the investor’s part also.”
The U.S. Securities and Exchange Commission on Feb. 23 sent out an investor alert on leveraged and inverse ETFs. “We believe individual investors may be confused about [their] performance objectives,” the release said.
Still, in a world where young investors are constantly looking for fast-paced ways to profit from market moves, some may find it hard to stop and educate themselves.
“They’re learning the hard way,” said Kashner. That’s my worry, she said.