An Exchange-Traded Fund (ETF) is a financial instrument that tracks indices or a unique set of stocks in different sectors. ETFs are categorized based on various parameters, including the index they track, industry focus, commodity ETFs, currency ETFs, and so on.
Index-tracking ETFs such as SPF ETFs and NDX ETFs are further classified as leveraged ETFs, inverse ETFs, etc. Today, we will look at what Leveraged Short ETFs are, how they work, and the merits/demerits of investing in them.
What are Inverse ETFs?
An inverse ETF is a trading strategy that allows investors to bet against market movement. An inverse ETF rises in value when the index, asset class, or commodity that it is betting against, falls in value. An inverse ETF is also known as a Short ETF or Bear ETF.
Inverse ETFs are created using derivative instruments such as options, swaps, and futures. Traders often use inverse ETFs as a hedging tool. It is worth noting that this ETF is ideal for daily trading purposes and must not be used as a long-term investing strategy.
Short ETFs are similar to the trading technique called “shorting.” In a short trade, a trader borrows securities and sells them to other market participants, in the hope of buying them back at a lower price during the day to unwind the position. However, if the security’s price increases, the trader has to buy back the security at a higher price and return it to the lender and pocket the loss. In essence, a trader is betting against the price movement of the security/asset class as he believes the price of the security will fall during the day.
The difference between short ETFs and short selling is that in the latter, the trader has to keep margin money in the brokerage account, whereas in a short ETF, you do not need margin money – you can simply buy the ETF as a hedge.
What is a Leveraged Short ETF?
In our last article, we discussed Leveraged ETFs and the pros and cons of investing in them. As the name suggests, “leverage” means to magnify the returns of an asset by using debt and/or derivative instruments.
Leveraged Short ETFs also magnify returns on an asset class by double (2x) or triple (3x) the amount. In a simple short ETF, the trader earns returns at the ratio of 1:1 to the security. In a leveraged short ETF, a trader earns returns double or triple times the fall in the asset class.
Generally, leveraged short ETFs come in two types: Double Inverse ETFs and Triple Inverse ETFs. These ETFs magnify the returns when the price of the underlying asset is falling.
For instance, in the case of a double-leveraged inverse ETF tracking the performance of the S&P 500 index (SPX), a 2% fall in the SPX will result in a 4% gain for the ETF holder (excluding fees). Whereas in the case of a triple-leveraged inverse ETF, the returns will be 6%.
Now, let us talk about expense ratios, one of the deciding factors when choosing between the several ETF options available in the market. A leveraged short ETF carries higher expense ratios compared to traditional ETFs, ranging from nearly 1% and above. This is because the expenses related to trading financial derivatives, and the management and transaction fees of managing a leveraged inverse ETF, are relatively higher.
Are Leveraged Short ETFs a Good Investment?
No matter how lucrative the returns of a leveraged short ETF may sound, they carry some shortcomings and caveats.
Merits of Leveraged Short ETFs
- Bet against the asset class – A leveraged short ETF allows traders to bet against a particular asset class and is relatively less expensive than short-selling.
- Hedging tool – This ETF style gives an investor exposure to derivative instruments and also can be used as a hedging tool.
- Potential for excess returns – As mentioned, a leveraged inverse ETF has the potential to generate returns above the underlying asset, mostly double or triple the times. An investor can benefit from excessive returns if he/she trades in leveraged inverse ETFs with caution.
Demerits of Leveraged Short ETFs
- Losses can be magnified immediately – Since leveraged short ETFs generate double or triple the opposite returns, a trader is exposed to magnified losses in case the asset class increases in value instead of an expected decline.
- Higher expense ratios – As compared to traditional ETFs, leveraged inverse ETFs carry higher expense ratios, and thus, diminish a fund’s returns.
- Short-term trades – As mentioned, leveraged short ETFs can only be used for short-term trading, spanning a day or less. The fluctuations in the underlying asset class can distort the returns when compounded over a period. Investors must not hold on to these ETFs as long-term investments.
List of Leveraged Short ETFs
Below are some of the leveraged short ETFs that investors can study and compare before making an investment decision. Click on any ETF ticker to further research them on TipRanks’ unique platform.
- Direxion Daily Semiconductor Bear 3x Shares (SOXS)
- ProShares UltraShort 20+ Year Treasury (TBT)
- ProShares UltraShort QQQ (QID)
- ProShares UltraShort Bloomberg Crude Oil (SCO)
- Direxion Daily Financial Bear 3X Shares (DRV)
Key Takeaways
Just as is the case with equity investing and mutual fund investments, ETF investments come with a wide variety of options. An investor must choose to invest in a leveraged inverse ETF only after fully understanding the outcome and as per his/her risk-reward appetite. These ETFs can also be used as a hedge against market trends, but amateur investors might find it best to steer clear of them.
As always, investors can use the TipRanks ETF page to research and study their performance and make informed investment choices.
