Leveraged, Inverse, and Futures-Based ETFs
PIABA Bar Journal, Vol 19, No 1 (2012)
26 Pages Posted: 18 Oct 2012
Date Written: July 1, 2012
Abstract
Exchange-traded funds (ETFs) offer retail investors a superficially simple way to obtain exposure to a wide variety of underlying assets and investment strategies. These products have become increasingly complex over time, and now many ETFs offer leveraged (multiple of daily returns) or inverse (negative multiple of daily returns) exposure to their underlying indices. Also, many ETFs that have commodities as their underlying assets obtain exposure to those markets not through purchasing the physical assets but through futures contracts, which involve complex “rolling” strategies. These leveraged, inverse, and futures-based ETFs show substantial deviations from the returns investors might expect or intend when they purchase them. This potential for misunderstanding could lead to substantial losses, especially since most of these ETFs grossly underperform the spot prices of their underlying assets. In this paper we describe the reasons for this tracking error in these two types of ETFs, highlighting their complexity and potential unsuitability for retail investors.
Keywords: Leveraged, Inverse Leveraged, ETF, Futures-Based, Commodities, Roll yield, Contango, Backwardation
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