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Understanding Leveraged and Inverse ETFs

Understanding Leveraged and Inverse Funds

You may have heard about funds that will deliver twice or even three times the performance of an index. There are also funds  that are inverse an index or double and even triple inverse. The SPY is the ETF that tracks the S&P 500 which is a stock index made up of 500 of the largest companies in the United States.  An example of a leveraged ETF is the SSO which is designed to have twice the daily movement of the S&P 500. There is also a short fund for the SPY called the SH, it will go up when the SPY declines. The SDS is a leveraged inverse S&P 500 fund so it will increase in value by two times the amount the S&P declines on a daily basis.

Leveraged and inverse funds are relatively new and can be good tools for portfolio management. Prior to having the inverse funds available, if an investor wanted to hedge a portfolio that has a high correlation to the S&P 500 they would have had to buy puts on the S&P 500 or short  a futures contract. Today an investor can simply buy shares of the SH or the SDS, which sounds simple enough.

Before purchasing a levered or an inverse fund it is critically important to understand the structure of the fund. They have added risks. The funds are designed to move up by twice the amount of an index, or move up if an index declines or move up double or triple the amount an index declines on a daily basis. The key word here is daily. Over longer time periods they will not perform with double leverage. Due to  what’s known as ‘roll costs’ and after factoring in how daily market volatility works, the funds may not perform well over longer time periods.

You can own a leveraged index fund, watch the index gain over a long time period and see the leveraged fund decline in value. Here’s a real world example as reported by the SEC, the Securities Exchange Commission. Between December 1st, 2008 and April 30th, 2009 a certain index gained 2%. A leveraged fund that delivered twice the daily performance fell by 6%. During the same time frame an ETF seeking to deliver three times the daily performance of an index fell by 53%, while the underlying index gained about 8%.

Read the prospectus and use caution when considering leveraged or inverse funds.