ETFs Can Be Plain or Fancy

From virtually nowhere, exchange-traded products have grown to more than $3 trillion in assets. A small portion of these products are exchange-traded notes (ETNs) but most are exchange-traded funds (ETFs): typically, pools of securities that trade like stocks.

A large amount of ETF assets, in turn, are in funds that track major stock market indexes such as the S&P 500 and the NASDAQ 100, as well as small-company indexes, foreign stock indexes, and so on. These ETFs tend to be low cost and tax efficient, so many supporters of a fiduciary standard for advisors believe the new rules favor ETFs as being in the best interests of many investors. Indeed, one Morningstar analyst has asserted that an estimated $1 trillion of investment assets will shift into ETFs.

Outside the box

However, not every ETF is a low-priced proxy for a major index. As ETFs have proliferated, they have spread into what seems to be every nook and cranny an investor might want to explore. For example, there are ETFs that track an energy stock index, ETFs that track exploration and production companies, even ETFs that track crude oil futures. There are ETFs that track specific foreign currencies, high-yield foreign bonds, certain hedge fund strategies, and so on.

In recent years, leveraged and inverse ETFs have gained popularity. Leveraged ETFs may be known as 2x or 3x ETFs, meaning that they move two or three times as much as the underlying index or commodity price or some other baseline.

Example 1: Ann Benson buys a 2X ETF that tracks the S&P 500. If that index goes up five percent, Ann’s ETF goes up by 10 percent. If the S&P 500 drops by five percent, Ann’s ETF suffers a 10 percent price drop.

Inverse ETFs move in the opposite direction of their benchmark.

Example 2: Carl Davis buys an inverse ETF that tracks the NASDAQ 100. If that index goes up five percent, Carl’s ETF goes down by five percent. If the NASDAQ 100 drops by five percent, Carl’s ETF enjoys a five percent price gain.

Some ETFs are both leveraged and inverse. Thus, they move in the opposite direction of the benchmark and those moves are magnified two or three times.

Example 3: Eve Foster buys a 2X inverse ETF on the Russell 2000 index of small company stocks. If that index goes up five percent, Eve’s ETF goes down by 10 percent. If the Russell 2000 drops by five percent, Eve’s ETF enjoys a 10 percent price gain.

Daily divergence

The preceding examples are simplified. In the real world, leveraged and inverse ETFs are more complex because these ETFs typically are reset daily. Over time, the results produced may vary widely from expectations.

Example 4: Suppose Eve Foster invests $10,000 in a 2X inverse ETF on the Russell 2000, as in example three, and the index gains five percent on Monday, from 1100 to 1155. Eve’s 2X inverse ETF falls by 10 percent, from $10,000 to $9,000.

Now suppose the index falls back to 1100 on Tuesday. That’s a 4.76 percent drop, from 1155 to 1100, so Eve’s 2X inverse ETF gains twice as much—9.52 percent—from $9,000 to $9,857. In the two-day period, the underlying index is back to where it started, but Eve’s 2X inverse ETF has lost value.

It is true that stock market indexes seldom move five percent on a single day. However, moves of one percent or more occur with some frequency, and the principle is the same. Especially if such an ETF is held for an extended time period, the daily resets can cause the result from holding a leveraged or inverse ETF to diverge widely from the performance of the underlying benchmark.

Proceed with caution

Leveraged and inverse ETFs pose risks, but there are reasons that they have grown in popularity. Used astutely, these ETFs might enable you to increase investment returns or hedge certain portfolio risks. If you work with a skilled advisor who is familiar with leveraged and inverse ETFs, you may be able to gain more control over your investments while boosting upside potential.

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