Leveraged funds are designed to produce a fund performance that is a multiple of the underlying index. A 2x fund should increase twice as much as the index. Inverse funds are designed to move in the opposite direction of the benchmark and they can also be leveraged.

Levered and inverse exchange trade products (ETPs) are designed to provide geared long and short exposures to the daily returns of various benchmark indexes. The benchmarks may be any reference index, but the popular ones are indexes of stocks, bonds, commodities and volatility.

The problem with these pro­ducts is that they are not generally well understood, particularly those with futures-based benchmarks. In a study conducted by Cheng and Madhavan (2009), they concluded that levered and inverse ETPs are neither suitable buy-and-hold investments nor effective hedging tools. They are unstable and exist only as mechanisms for placing short-term directional bets. Levered and inverse products are not, and cannot be, effective investment management tools.

No example was more clear than the situation revolving around the collapse of the price of oil, at the height of the virus-induced crisis back in March. Citigroup’s Velocity­Shares 3x Long Crude Oil exchange-traded note (UWT) nearly tanked on March 9, when its benchmark index dropped 73.5 per cent, just shy of the 75 per cent acceleration clause that would have triggered termination.

On March 15, ProShares announced the liquidation of its UltraPro 3x Crude Oil (OILU) and UltraPro 3x Crude Oil (OILD) exchange-traded funds (ETFs). Two years earlier, Credit Suisse closed its Daily Inverse VIX Short Term ETN (XIV) after it lost 96.3 per cent of its value in a single day.

Naturally, these types of events are confusing to most investors and undermine investor confidence in financial markets. The fact of the matter is that the value-destroying characteristics of these products are not well understood, especially by retail investors. The argument for more regulation, in terms of investor suitability profiles, persists.

Levered and inverse funds are controversial for good reason

The main attraction of geared (levered) and inverse funds is that they offer an inexpensive, convenient, highly-levered and limited-liability means for pro­fiting from a directional price view. If an investor has a strong view that the stock market will rise over the next few weeks, a leveraged S&P 500 ETF might be suitable. Trading costs and barriers to entry are low, and bid-ask spreads on these pro­ducts are trivial for active ETPs.

An alternative would be to open a futures account; however, one may not be able to open futures accounts because of account and personal wealth minimums. Yet, retail customers can quickly and cheaply achieve six times leverage on the S&P 500 Index by buying on margin.

The most important problem with geared (levered) and inverse funds is that most of them are expected to collapse, thereby inherently not making them suitable to be a long-term investment. The longevity of a levered or inverse ETP depends critically on the expected return and volatility of the fund’s benchmark index. Irrespective of the expected return of the benchmark index, various litera­ture reviews have shown them to eventually fail.

This is especially true for futures-based indexes that assume the idiosyncrasies of the futures contract prices on which they are based. In markets such as crude oil and natural gas, volatility hedging imbalances creates a negative expected return, even for unleveraged products.

Finally, the realised daily ETP return is different from its levered benchmark return for a variety of reasons, including management fees, licensing fees, operating costs, contract indivisibilities, basis risk or slippage, and front running. The difference between the daily return of the ETP and the daily return of the benchmark is called “tracking error” and is useful in assessing the degree to which issuers have achieved their stated investment objectives.

Levered and inverse funds are controversial for good reason. Unlike typical securities traded on exchanges, their expected long-run values are zero. Is this fact hidden? No. Product issuers say so in their prospectuses. They are best used sparingly and with extreme caution.

Simon Psaila is an investment manager at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

For more information visit https://cc.com.mt. The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.