Inverse, leveraged and volatility ETFs: What’s the difference?

Investing in the stock market offers a variety of strategies beyond the traditional buy-and-hold approach. Leveraged, inverse and volatility ETFs present unique opportunities for investors interested in more sophisticated strategies. However, it's crucial to understand that these types of ETFs carry a high level of risk and complexity and are not intended to be long-term investments. While leveraged ETFs generally seek to deliver multiples of the daily performance of the index or benchmark that it tracks, inverse ETFs generally seek to deliver the opposite of the daily performance and volatility ETFs focus on market fluctuations. Despite their potential, these tools can be extremely risky, and investors should approach them with caution. Let's delve into the details, starting with the fundamentals.

What is an ETF?

An ETF is a package of investments – such as stocks, bonds, derivatives and more – that trades on an exchange like a single stock. Traditional ETFs typically seek to replicate the performance of an index, offering investors a relatively easy and cost-effective way to invest in a wide range of assets. For example, by investing in an ETF that tracks the S&P 500 index, investors gain exposure to all 500 of the largest companies in the U.S. stock market. The structure of an S&P 500 index ETF is also pretty simple. The fund manager must simply maintain a portfolio of individual stocks according to the weightings of companies within the S&P 500 index.

While many ETFs generally follow traditional investment strategies, others, like inverse, leveraged and volatility ETFs, employ more complex methodologies to achieve specific results. Understanding how these strategies work is key to using them wisely.

What are inverse ETFs?

Inverse exchange-traded funds (ETFs) typically aim to deliver the opposite of the daily performance of the index or benchmark they track. They provide the opposite performance of an underlying index over a one-day period. For instance, if the S&P 500 drops by 2% in one day, an inverse ETF tracking that index is generally designed to gain 2% before fees and expenses.

Inverse ETFs use derivatives like swaps, futures or options to achieve their inverse performance, which can lead to higher costs, and investors should consider a fund’s costs (or “expense ratio”) before making an investment decision. They are designed for short-term use, and holding them for longer periods can result in performance that deviates from the expected inverse of the index due to daily resetting.

What are the risks of inverse ETFs?

Inverse ETFs carry unique risks due to their structure and daily rebalancing. These funds are generally designed for short-term holding, typically less than a day. At the end of most trading days, inverse ETFs undergo a process called resetting, where the components of the ETF are reset to their stated allocation percentages.

What are leveraged ETFs?

Leveraged ETFs generally aim to deliver multiples of the daily performance of the index or benchmark they track. For example, a 2x leveraged ETF is generally designed to deliver twice the profits or losses of the reference index each day before fees and expenses. If the index rises 3% in a day, the ETF would increase 6%. But if the index drops 3%, the ETF would fall 6%.

To understand leverage, imagine you have $10,000 and borrow another $10,000 to invest $20,000 in total. If your investment gains 5%, you now have $21,000. You pay back the borrowed $10,000, and your total return is $1,000, or 10% of your original $10,000. Borrowing doubled your potential return on your original money, but also exposed you to double the potential losses. Leveraged ETFs use similar principles, employing tools like swaps and futures to amplify returns.

One crucial aspect to understand about leveraged products is that they typically mark returns based on the daily performance of the underlying benchmark. A leveraged ETF is essentially marked to market every night. It starts with a clean slate the next day, almost as if the previous day had not existed. This process produces daily leverage results. However, over time, the compounding effect of this reset can potentially lead to a significant divergence in performance of the fund versus its underlying benchmark and expose investors to rapidly compounding losses for each additional day they hold the investment.

What are the advantages of leveraged ETFs?

What are the risks of leveraged ETFs?

What are volatility ETFs?

Volatility ETFs are designed to track market volatility using futures contracts tied to the CBOE Volatility Index (VIX). Unlike stock-based ETFs, these funds don’t invest in companies or tangible assets. Instead, they reflect market sentiment – rising during periods of uncertainty and falling when markets are stable.

The VIX, often called the “fear index,” measures expected market volatility. When traders expect sharp market movements, the VIX rises. Volatility ETFs attempt to capture this movement, making them useful for traders anticipating sudden spikes in market uncertainty.

What are the advantages of volatility ETFs?

What are the risks of volatility ETFs?

It’s important to note that VIX ETFs don’t directly track the VIX itself. Instead, they follow VIX futures indexes, which creates some unique challenges:

VIX exchange traded products may be structured as Exchange Traded Notes (ETN), commodity pools or overlay ETFs, which add layers of complexity:

How can resetting affect inverse, leverage and volatility ETFs?

All three types of ETFs – inverse, leveraged and volatility – undergo daily resetting to maintain their target performance. This process resets their exposure to the underlying index or asset, which can lead to compounding costs and performance divergence over time.

For example, if an index rises 5% one day and falls 5% the next, its overall performance is slightly negative. However, a leveraged or inverse ETF tracking this index may experience even larger deviations due to daily resets. This makes these ETFs designed only for short-term strategies.

Are inverse, leverage and volatility ETFs for the average investor?

While inverse, leveraged and volatility ETFs offer different opportunities for active traders, they come with significant risks and complexities.

Due to their complex structure and costs, leveraged, inverse and volatility ETFs are not designed as long-term investments. In fact, these funds aren’t always the best choice during volatile markets, given their liquidation risks. Based on data from Morningstar, 90 leveraged and inverse ETFs were liquidated in 2020 during the higher market volatility caused by the COVID-19 pandemic. In contrast, when markets were less volatile in 2021, there was just one liquidation of a leveraged or inverse ETF.

These funds are typically geared toward experienced investors who understand their mechanics and risks and can monitor them closely. For most investors, traditional ETFs with simpler structures are safer for long-term goals. Consider speaking with a qualified financial advisor for more specific information.

The bottom line

Inverse, leveraged and volatility ETFs are advanced tools for investors looking to capitalize on specific market movements. They provide unique ways to profit from market declines, amplify returns or trade on volatility. While these ETFs might be useful for short-term strategies, they are generally considered poorly suited for a long-term portfolio due to their risk, complexity and generally short holding periods. If you’re considering these ETFs, you should make sure you understand the pros and cons and how to use them for your portfolio by conducting your own research to ensure these ETFs are aligned with your investment goals and risk tolerance. You can also consult a financial advisor to see if these products are appropriate.

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