Inverse and Leveraged ETFs: Not Your Father’s ETF

Abstract

First-generation ETFs were designed as convenient, straightforward investment vehicles for earning the returns of broad market indexes. The rapid growth and competitiveness of the ETF industry has led to the development of products that bear more complicated relationships with market indexes. The first wave of these, leveraged and inverse ETFs, were engineered to meet objectives quite different from those of the traditional ETFs. This article shows how investors who used them like traditional ETFs experienced unintended consequences during the volatile markets of 2008–2009. The author explains how the daily rebalancing of leverage affects the valuation and determines the appropriate usage of such ETFs.

TOPICS: Exchange-traded funds and applications, passive strategies, portfolio theory