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How Inverse Leveraged Exchange Traded Funds Work

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 9/29/2009

Before investing in any securities, an investor should understand the vehicle they are putting their money into. This is especially true for leveraged ETFs and inverse leveraged ETFs, which do not work the way typical investments do.

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    Leverage ETFs Performance and Function

    It is very important to understand how leveraged ETFs and inverse leveraged ETFs work. Unlike more typical ETFs and mutual funds which typically trend over time in the same direction as their benchmarks, leveraged ETFs are less and less likely to resemble their target’s performance over longer periods of time. This can generate surprising (shocking) results if investors don’t completely understand them.

    Many investors use the recommendations of friends, or of financial publications or analysts to help determine which investments to purchase. Most of the time, while not necessarily ideal, this practice at least conforms with the standard expectations of even novice investors. But, this can be very dangerous when it comes to leveraged ETFs. The reason lies in how leverage affects the performance of an ETF.

    Many leveraged ETFs seek to provide a return that is equal to a multiple of a targeted index for a SINGLE DAY. For example, ProShares Ultra QQQ ETF seeks to return 200% of the return of the NASDAQ-100 Index every day, while the ProShares Ultra Short Dow30 seeks to return 200% in the opposite direction of the Dow Jones Industrial Average. Thus, if the funds meet their goal over a single day, then the ProShares Ultra QQQ would increase by two times the percentage increase of the QQQ that day, or decrease by 2x the percentage decrease of the QQQ on that day. Likewise, the UltraShort Dow 30 would return twice the percentage decrease of the Dow Jones index on a down day for the Dow, and it would lose twice as much as the Dow increases by for that day.

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    Long-Term Leveraged ETF Performance

    Where many investors get tripped up is understanding how the leverage inside of these ETFs can cause the long-term returns of these investments to vary greatly from the long-term performance of their targeted indexes. Indeed, a leveraged ETF could be down significantly over a long measuring period while its targeted index is up a lot, and vice versa. How does this happen?

    By doubling the return of the ETF through leverage, the movements in the leveraged ETF will be greater than the movements of the underlying index. Additionally, since the return of the leveraged investment is a multiple of the underlying investment’s performance that means that large price movements will have a much greater impact on the leveraged ETF than smaller movements.

    How does this affect the overall returns over time? The key to the answer requires understanding how percentages compound on subsequent calculations. Because larger price movements are magnified by leverage, and because those magnifications may occur on values that are much larger or smaller than the original investment the value of the ETF over time can vary dramatically from its index.

    FINRA (formerly the NASD) offers this example to demonstrate this effect:

    "Here’s a hypothetical example: let’s say that on Day 1, an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 20 percent on that day and have an ending value of $80. On Day 2, if the index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 20 percent, which means the ETF would have a value of $96. On both days, the leveraged ETF did exactly what it was supposed to do—it produced daily returns that were two times the daily index returns. But let’s look at the results over the 2 day period: the index lost 1 percent (it fell from 100 to 99) while the 2x leveraged ETF lost 4 percent (it fell from $100 to $96). That means that over the two day period, the ETF's negative returns were 4 times as much as the two-day return of the index instead of 2 times the return." – From Leveraged and Inverse ETFs Investor Alert

    Completely Understand Leveraged ETFs Before Investing

    Legal disclaimers and financial writers and journalists are always saying to understand your investments and to read the prospectus before investing any money. They say it so often, that many investors have stopped listening. While it is always good advice, it is critical when it comes to leveraged ETFs.

    Leveraged ETFs do not do what it seems like they would intuitively do over a period of time greater than one day, so unless you plan to buy and sell your QLD on the same day, don’t even think about investing until you’ve read the prospectus, and in particular, the examples about how the ETF behaves over time.

    Get the proper knowledge and experience first, and leveraged ETFs can be a powerful investment to have at your disposal.