Despite Their Popularity On Social Media, These Funds Are Risky Investments.

Young investors who get their daily fix of finance from social media apps like Tik Tok and Discord have been bombarded with pitches for inverse and leveraged ETFs that have been marketed to their feeds for quite some time.

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Inverse ETFs are able to deliver negative and positive multiples of their underlying index's performance, respectively, when compared to leveraged ETFs. Market enthusiasts have advocated the use of these products on social media as a way to lock in gains amidst the Federal Reserve's rate hikes in 2022 that caused the market to decline.

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Make sure you know what you are getting into before you make a purchase. In the wrong markets, ETFs with high volatility, especially those with leverage, can quickly mount big losses if the market doesn't go their way.

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Consider an aggressive inverse ETF that offers three times the daily inverse of the Nasdaq, such as the ProShares UltraPro Short QQQ –1.91% (ticker: SQQQ). The ETF gained 82% last year when the tech stocks were bleeding. A long bull runs for technology companies ended in a loss of 61% for the ETF in 2021 as well as an 86% loss in 2020. The ETF has lost a median of 51% per year over the past ten years, based on an annualized basis.

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As of now, investors do not seem to be scared by the risks associated with the stock market. In 2022, equity-based inverse and leveraged ETFs saw net flows of $27.37 billion, the highest level in the history of these products, according to Morningstar data. The net flow of a fund refers to the difference between the amount of cash that enters and leaves the fund.

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Within the equity, debt, and commodity markets, 40 inverse and leveraged products were launched in the U.S. over the past year, which is the highest level seen since 2011. Several new products have been launched this year, with more expected to follow in the near future.

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Ken South, a registered financial advisor and CEO of Tower 68, told Trade Algo that there is a desire to participate in declines in more ways. This has led to the industry creating more and more ETFs in order to meet the demand, he said.

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The use of these tools to hedge the short-term declines in the value of your investment can make sense in certain circumstances for experienced investors; South uses these tools on occasion in client portfolios to hedge the short-term declines in the value of their investments. Although these so-called geared ETFs come with high fees and expenses along with the inherent risks associated with daily rebalancing, investors who aren't regularly tuning their portfolios and aren't comfortable handling aggressive risks may find them risky long-term—or even medium-term—bets.

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Among Direxion's extensive portfolio of leveraged ETFs, there are many to choose from. The company explains its products by showing a roller coaster ride of a trader who buys ETFs through the use of a real-life example, but let's take a closer look at Direxion Daily Energy Bull 2X Shares (ERX –0.77% ERX) as an example. In the event that the underlying index of this ETF, the Energy Select Sector Index (IXETR) loses 10% at the end of the first day of trading and you were to own $100 worth of shares of this ETF, the ETF would be down 20% to $80 at the end of the first day of trading.

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Alternatively, if the index closes at 99 on day two, the ETF would be up by 20% to $80 or at $96. The leveraged ETF would achieve its stated objective of two times daily returns on both days, but it would lose 4% overall instead of 1%, making longer-term returns particularly volatile.

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It's really counterintuitive, and it's hard to get your head around,” Elisabeth Kashner, FactSet's director of ETF research, explained. “It takes a lot of investment education in order to use them, and they are hard to use over a long period of time,” she added.

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Apart from understanding the underlying risks and having a strong conviction about the direction that the index will take, investors should also take note of the high costs associated with this index. There are an average of 1.02% in fees and expenses charged by leveraged and inverse products, which are much higher than the average 0.61% on average charged by thematic ETFs and 0.095% on an SPDR S&P 500 ETFSPY +0.33%  (SPY). Investors may want to use FINRA's Fund Analyzer to estimate the impact of expenses on their investments and to estimate the impact of expense ratios on their returns.

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The manager of Tuttle Capital Management, Matthew Tuttle, believes that the 0.85% management fee charged by its fund is appropriate considering that he filed for the Tuttle Capital 2X DBMF ETF last month, which measures the daily performance of the iMGP DBi Managed Futures Strategy ETF (DBMF). It is because the new product is offering two times the exposure for the same price as iMGP's product, he explains. Following the creation of the hugely popular AXS Short Innovation Daily ETF (SARK) on Thursday, Tuttle launched the Inverse Cramer ETF (SJIM) on Friday.

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There is a growing movement in the industry of leveraged and inverse ETFs, led by ProShares and Direxion, that both state in their prospectuses and on their websites that these funds are not suitable for all investors, and they should not be considered by buyers who intend to hold them for a long time. As part of their investor education program, both companies also have a tab dedicated to it.  

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Tuttle puts the onus on investors. “I strongly believe that investors should be educated about finances, whether they delegate or not,” he wrote. “This is one of many tools investors can use to express their views, but more tools require more work on the investor's part.”

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There has been an investor alert sent out by the Securities and Exchange Commission on Feb. 23 regarding leveraged and inverse ETFs. “It is our belief that individual investors may be confused about [their] performance objectives,” according to the release.

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Some may find it difficult to stop and educate themselves, especially in a world where young investors are constantly looking for fast-paced ways to profit from market movements.

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"They're learning the hard way," Kashner said. That's my concern, she said.

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