With the ETF industry gaining in leaps and bounds in recent years, the use of leveraged inverse ETFs (often known as ultra-short funds) has grown rapidly. These products occupy a small slice of the ETF space.
Leveraged inverse ETFs provide opposite exposure that is a multiple (-2X or -3X) of the performance of the underlying index. These funds employ various investment strategies such as use of swaps, futures contracts and other derivative instruments to accomplish their objectives. Due to their compounding effect, investors can enjoy higher returns in a very short period of time, provided the trend remains a friend (read: 5 Leveraged/Inverse ETFs That Gained Double Digits in August).
Since most of these ETFs seek to attain their goals on a daily basis, their performance could vary significantly from the inverse performance of their underlying index or benchmark, over a longer period when compared to the short period (such as, weeks, months or years) due to their compounding effect. This phenomenon can be explained with an example below.
Imagine that an investor buys a leveraged inverse ETF for $100 that has two times (2X) exposure to the underlying index of say 10,000. If the index goes up by 1% to 10,100 on day 1, then the market price of the ETF moves down by 2% to $98 on the same day. Again, when the index goes up by another 1% to 10,201 on day 2, then the ETF value goes down by another 2% to $96.04. Over the last two days, the index is up by 2.01% while the ETF is down by 3.96% (approximately two times as stated by the fund objective). As a result, the performance of the fund and index can vary as we take longer periods for consideration.
Investors should also note that leveraged inverse ETFs involve a great