Leveraged & Inverse ETFs
A tool to amplify returns without additional capital, and stay in the green when market turns south.
Introducing Two New Strategies
Two new Exchange-Traded Fund (“ETF”) strategies will soon be introduced on the Main Market of Bursa Malaysia; the leveraged, and inverse strategies. These strategies will provide an avenue for investors to either double their investment exposure into an index through a (2x) Leveraged ETF, or gain the reverse (inverse) performance of the index through a (-1x) Inverse ETF.
What is a (2x) Leveraged ETF?
Leveraged ETFs provide you with the ability to multiply your market exposure without having to put in additional capital, or to apply for financing from your broker.
To provide leveraged returns of its underlying index, the ETF will multiply its positions on an underlying index through derivatives i.e. futures contracts. It is important for you to identify and comprehend the underlying index tied to the ETF, because different ETFs will provide you with exposure to different underlying indices.
For example, if you believe that Index A is set to see a positive performance in the short-term, buying into an Index A (2x) Leveraged ETF will give you a multiplied result of the index performance by 2 times. By doing so, if Index A sees a positive return of +2%, the Index A (2x) Leveraged ETF will provide you with a return of +4%. In this example, Index A could be any index determined by the ETF Issuer, and may represent indices such as FBM KLCI, S&P500, Hang Seng Index, Hang Seng China Enterprises Index, etc. So, don’t forget to check which index you’re buying into.
What is a (-1x) Inverse ETF?
Inverse ETFs are the rebels that provide you with the opportunity to go against markets.
To provide an inverse return of its underlying index, the ETF will hold short positions on an underlying index through derivatives i.e. futures contracts. Just like the Leveraged ETF, it is important for you to identify and comprehend the underlying index tied to the ETF, because different ETFs will have a different underlying index.
For this strategy, if you believe that Index A is set to see a negative performance in the short-term, buying into an Index A (-1x) Inverse ETF will give you the opposite results of the index performance. So if Index A sees a negative return of 2%, the Index A (-1x) Inverse ETF will provide you with a positive return of +2%.
Besides providing you an opportunity to provide your portfolio with positive returns in down markets, Inverse ETFs can also be used for hedging your portfolio.
For example, what would you do with your portfolio of stocks if you have a negative view on the index? You obviously bought into these stocks because you have a longer-term positive outlook on these companies. Do you hold on to these names and ride out the volatility? Or do you sell-down your entire portfolio and hope to buy these stocks back at a lower price?
With Inverse ETFs, you will not only be able to maintain your portfolio intact but also hedge your position, as the Inverse ETF would basically square-off your market position. Without selling your portfolio of stocks, the positive returns from the Inverse ETF of 2% offsets your portfolio loss of 2%, which is essentially the concept of hedging.
However, returns are comparable on a daily basis only. Why?
There is a need for a daily reset in exposure levels to make sure that investors will have that exposure they crave for when they trade into the ETF. For example, a (2x) leveraged ETF will aim to provide investors with a 200% exposure, whilst a (-1x) inverse ETF will aim to provide a -100% exposure.
What happens when the daily rebalancing doesn’t take place? This would result in a deviation between your investments, and the total exposure the ETF is giving you. For example, you invest RM100 into a (2x) Leveraged ETF on day1. That RM100 would essentially be providing you with RM200 worth of exposure into the underlying index as the ETF magnifies the performance of your investment by 2x. The end of day-1 sees the underlying index gaining 10%, which means your investment value is now RM100 + (10% of the underlying index exposure of RM200) = RM 120.
The exposure into the underlying index is now valued at RM200 + the 10% gain = RM220. To continue to provide you with a 200% exposure, the ETF would need to be rebalanced and bring its exposure value into the underlying index to 2x the value of your investments of RM120, i.e. to RM240.
If the underlying index climbs higher by a further 10%, the value of your investments with move higher from RM120 to RM144 (RM120 + (10% of RM240)). However, if the rebalancing does not take place daily, the 10% increase in underlying index would only bring your investment value to RM 142 (RM120 + (10% of RM220)). The same theory also applies for the (-1x) inverse ETF strategy.
This is also the reason why cumulative returns of the (2x) leveraged ETF DOES NOT EQUAL to 2x the underlying index’s return over the longer term: the compounding effect, and daily rebalancing. Which is why these leveraged, and inverse strategies are commonly used as daily trading tools, and should not have its returns compared against its underlying index when looked at over a period longer than 1-day.
What else would you need to know about these strategies?
A (2x) Leveraged ETFs aims to amplify your investment results, meaning returns on your investment would be multiplied, both on the upside and on the downside. For example, whilst your investment returns could be doubled to provide you a 4% gain when the underlying index is up by 2%, the results are the same in the reverse. I.e. if the underlying index records a loss of 2%, your investment return would be a loss of 4%.
Conversely, as the Inverse ETF provides the reverse results of the index, your investment returns would be positive if the underlying index performs negatively. Do note that in a reversed scenario where the underlying index performs positively, your investment returns would then be negative.
You may then ask what the difference is between trading the futures yourself. Trading a (2x) Leveraged, and (-1x) Inverse ETF provides you with the exposure without the hassle of monitoring your exposure. Did you know that there are expiration dates to the futures contracts that you buy into? There may be negative impact on your portfolio if these futures contracts are not rolled-over within the stipulated timeframe. Through an ETF, monitoring of these activities will be done by a Fund Manager, thus there will be no headache of managing timelines from an investors’ perspective. Further to that, each futures contract usually comes in multiples of 50 of the index point, which means you will be exposed to a relatively high investment amount despite not having to pay the full sum to invest due to only needing to meet the futures margin requirements.
When, what, how?
The listing of these ETFs is slated to take place end-November 2019, so stay tuned for more news on this. The introduction of these new strategies will be made using a wide range of underlying index, which could give you access to foreign markets, providing you with ease of investment through the Main Market of Bursa.
Given that these strategies are considered more sophisticated than your average stocks, and conventional ETFs, you would be required to carry out a checklist declaration with your broker to setup your account and have your account operationally ready for trading. Speak to your brokers to find out more on how you can start trading Leveraged & Inverse ETFs.
Whatever your take on the market is, we’ve got a trading tool for you.
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