Understanding Inverse Leveraged ETFs – Advanced

This is a working paper authored by Patrick Collins on Inverse Leveraged Exchange Traded Funds (ETFs). It is a moderately advanced article laced with some complex investment concepts and calculations. Like artificial sweeteners to your health, Inverse Leveraged investments can be dangerous your investment portfolio. Although this study does not argue that inverse leveraged ETFs are per se imprudent, these instruments are used by traders and market makers to hedge inventory risk exposures on a day-by-day basis. Additionally, investors with well-defined short-term liabilities might consider using these financial products to protect assets that are specifically earmarked to defease the liabilities.  In general, however, we assert that investors are better off avoiding inverse leverage ETFs.  The risks of losing your money make this “sweet” investment rather unappealing.

Inverse Leveraged ETFs are vehicles to capture returns based on predictions about the magnitude and direction of market price movements.  For example, if an investor expects a fixed income or stock index to lose value, an inverse leveraged ETF offers the opportunity to take a “short position” against the index.  This means that if the investor’s market direction call is correct—i.e., the price of the stock or bond index goes down—the price of the inverse leveraged ETF will go up.  The investor makes money while the owners of securities suffer declines in their portfolio’s value.  We analyze the prudence of investing in leveraged inverse exchange traded funds. One of the paper’s main points is to identify the risks associated with these investments. A second, and potentially more alarming, issue is in the asymmetric loss/return opportunities in these investments (greater downside risk than upside return).

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