In Part 3, we will explore riskier ETFs, suitable for investors with a high-risk tolerance or those with short-term investment horizons. These include leveraged and inverse ETFs, which are not intended to be held longer than one day due to their volatility. These ETFs typically carry higher management fees than traditional ETFs due to the frequent buying and selling of their underlying derivatives.
Complex ETFs
Complex ETFs employ advanced investment tactics beyond simple index replication, differing from traditional ETFs. These instruments offer diverse payout structures, perform unpredictably under various market conditions, and may utilise derivatives or short selling. When used appropriately, complex ETFs can provide portfolio diversification, substantial growth opportunities, or downside protection.
- Leveraged ETFs – Leveraged ETFs aim to amplify the daily movement of an index or benchmark. While a standard ETF tracks the underlying securities on a 1:1 basis, leveraged ETFs seek to achieve returns of 1.5:1, 2:1, or even 3:1. Most leveraged ETFs target twice the daily return of an index or asset, using financial instruments like swaps and futures. Due to daily rebalancing, they may deviate from expected long-term returns because of compounding effects. Investors might buy leveraged ETFs if they anticipate a short-term surge in a stock index. An example of a leveraged ETF is ProShares UltraPro QQQ, which delivers 3x exposure to the NASDAQ-100 Index.
- Inverse ETFs – Designed to replicate the opposite daily movements of an index or benchmark, inverse ETFs rise when the underlying index falls. Investors choose inverse ETFs to profit or hedge against market declines. Inverse ETFs can be leveraged or unleveraged. Unleveraged inverse ETFs aim to deliver the inverse of the daily performance of an underlying index on a 1:1 basis. Leveraged inverse ETFs amplify the inverse of the daily performance, such as 1:-2 or 1:-3 basis. For instance, the ProShares UltraPro Short QQQ provides -3x inverse exposure to the NASDAQ-100 Index.
- Hedge Fund ETFs – Hedge Fund ETFs aim to replicate the trading activity and strategies of traditional hedge funds, but with the liquidity and transparency typical of ETFs. While access to hedge funds is often restricted to high-net-worth individuals, hedge fund ETFs allow everyday investors to access popular hedge fund strategies. Some of these strategies include merger arbitrage (investing in companies involved in mergers), long-short equity strategies (betting on winning stocks to rise and losing stocks to fall), and managed futures (trading on futures contracts). Hedge fund ETFs strive to match the returns of hedge funds by mirroring their investments. An example is the Global X Russell 2000 Covered Call ETF, which buys stocks from the Russell 2000 Index and sells corresponding call options to generate income through covered call writing.
According to Statista Research Department, the number of ETFs worldwide grew from 276 in 2003 to approximately 8,754 in 2022. As ETFs have become more popular, providers have introduced more intricate ETFs. However, ordinary investors should be cautious with complex funds. While complex ETFs may multiply your gains, they can also multiply your losses. Although the potential returns may seem attractive, many investors may not fully recoup their initial investment in these complex ETFs.
Disclaimer: ProsperUs Manager of Content Hailey Chung doesn’t own shares of any ETFs mentioned.
