Rebalancing Act: A Primer on Leveraged and Inverse ETFs

Wed Oct 07 16:24:38 EDT 2009
By Raymund Wong and Kara Hargadon

In this paper, NERA Senior Consultant Raymund Wong and Associate Analyst Kara Hargadon provide an overview of leveraged and inverse exchange-traded funds (ETFs), which, perhaps due to recent market turmoil, have become a popular tool for investors to hedge their positions or gain greater exposure to index movements. While some leveraged and inverse ETFs have been among the most highly traded securities in the stock market, a consensus on the return characteristics and suitability of leveraged and inverse ETFs for retail investors has yet to be formed. Opinions have been expressed at one extreme that these securities are absolutely inferior to other leveraged investing methods, such as margin accounts or purchasing derivative securities directly. Other research and analyses suggest that these securities can be an appropriate vehicle for properly informed investors. As with many other instances of recent financial innovation, it remains to be seen whether the recent controversy over leveraged and inverse ETFs will eventually prove to be an unfortunate byproduct of the financial crisis, or the result of an ill-designed security exposed by the same. This paper describes the effect of rebalancing leverage ratios for leveraged and inverse ETFs, recent developments and controversies, the impact of recent market turmoil, disputes and litigation, and what is next for these securities.