Are leveraged and inverse exchange-traded funds worth the risk?
With investors flocking to the stock market and ETF industry at historically low interest rates, issuers hope that buyers will do their homework before engaging in some of these complex strategies.
Both leveraged and inverse ETFs use financial derivatives in their underlying constructs. Leveraged ETFs use derivatives and debt instruments to multiply the returns on their underlying indices, for example, tracking stocks on a 2-to-1 basis instead of the standard 1-to-1 basis. Inverse ETFs are designed for those who want to benefit from an index decline.
However, both types of ETFs tend to reset their holdings daily, indicating that they were built for day traders rather than long-term investors, David Mazza, product manager at Direxion, told CNBC̵
“As a provider of leveraged and inverse ETFs, we want to make sure that people use them appropriately and correctly. And they’re really meant for traders or people who have the ability and potential to pay close attention to their portfolios.” he said. “For investors who use it appropriately, many of them may find it helpful … as part of their overall strategy. However, they are not intended to be long-term buy-and-hold investment vehicles.”
At the end of last year, the Securities and Exchange Commission proposed rules that leveraged and inverse ETF providers must ask their customers a series of questions to ensure that they understand the risk associated with purchasing these products. The issuers pushed back and said this could destroy this corner of the market.
Recently, demands for re-regulation or reclassification of these types of funds in the ETF community have increased, which has led to more intensive testing of these vehicles.
Tom Lydon, CEO of ETF Trends and ETF Database, admitted that these funds are “not a toy”.
“They are an integral part of the ETF ecosystem, and this latest campaign was not released by the SEC. It was released by other ETF issuers who do not have a dog on the hunt,” Lydon said in the same “ETF Edge” interview .
“So is it really for the benefit of investors? Maybe. Is it also a competitive step? It could be. But the horse has definitely left the barn here,” he said. “Investors who want to shoot themselves in the foot are unlikely to turn to ETFs. They are likely to go to the futures or options market or penny stocks or the like.”
Ultimately, Mazda and Lydon agreed that investor intestinal controls should not come from regulators.
“Whether it is a two or three-time service, what brings this service up or down is what is in the shopping cart. We therefore recommend everyone to understand this … more if you use it tactically want, this is even more true if you try to exchange it for a shorter term opportunity, “said Mazza.
“I think it makes sense for investors to be informed and we want to educate people about it further, but trying to split up an already confused issue would almost confuse investors if we end up with more categories than there “, he said.
Lydon was also on the issuer side, warning that higher levels of regulation could threaten the ETF industry as a whole.
“If you suddenly want to buy a reversal [or] Lever ETF and you go into your Charles Schwab account and try to buy it and a skull shows up. Is it really good for the industry when most people do their homework? “said Lydon.
“I think we have to look at everything as a whole,” he said. “And we will continue to have educational barriers that will exist, but let’s throw all these types of ETFs – not just inverse and leveraged ones, but also others that may have futures contracts or overlays and things like that – all in one bucket and say : “These are more sophisticated?” Really not sure. I think that’s one thing we’ll talk about further, and that’s the great thing about the industry. It’s very democratic. “
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