Leveraged and Inverse ETFs are becoming increasingly popular. Before jumping in, here are a few things you should know

If you are a young investor who gets your daily dose of finance on social media applications like Tik Tok and Discord, you have probably seen advertisements for inverse and leveraged exchange-traded funds, or ETFs.

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Inverse and leveraged ETFs provide negative and positive multiples of the performance of their underlying indexes, respectively. Market aficionados have been advocating these products on social media as a way to lock in profits in the face of Federal Reserve rate rises, which have resulted in the market falls in 2022.

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When you buy one, be sure you understand what you're getting into. These volatile ETFs, especially those with leverage, can quickly accumulate massive losses in the wrong market.

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Consider an aggressive inverse ETF like the ProShares UltraPro Short QQQSQQQ -6.13% (ticker: SQQQ), which provides three times the daily inverse of the Nasdaq and gained 82% last year when tech firms were bleeding. The ETF also fell 61% in 2021 and 86% in 2020 as technology companies completed a long bull run. Over 10 years, the ETF has lost 51% per year.

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For the time being, investors remain unconcerned about the hazards. According to Morningstar statistics, equity-based inverse and leveraged ETFs recorded net flows of $27.37 billion in 2022, the largest amount in the product's history. The net flow of a fund is the difference between cash in and cash out.

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In the equities, debt, and commodities markets, 40 inverse and leveraged products were introduced in the United States last year, the most since 2011. At least four have been launched this year, with more to follow.

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There is a "desire for an increasing variety of methods to engage in decreases," according to Ken South, certified financial advisor and CEO of Tower 68. This has prompted the industry to develop additional ETFs, he says.

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Using these strategies to hedge against short-term drops in the value of your investment might make sense in specific conditions for experienced investors; South employs them in client portfolios occasionally. But, the high fees and expenditures associated with these so-called geared ETFs, along with the inherent hazards of 'daily rebalancing,' make them dangerous long-term—or even medium-term—bets for investors who aren't continually adjusting their portfolios and aren't comfortable managing aggressive risks.

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Consider one of Direxion's several leveraged ETF portfolios. The business promotes its products by depicting an eager trader on a roller coaster purchasing ETFs, but let's look at the Direxion Daily Energy Bull 2X Shares (ERX +2.71% ERX) as an example. If you own $100 in this ETF and its underlying index Energy Select Sector Index (IXETR) falls 10% after day one trading, the ETF will be down 20% at $80.

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But, if the index gains 10% on day two to close at 99, the ETF would be up by 20%, or $96. It would meet its stated goal of two times daily returns on both days, but the leveraged ETF would lose 4% overall, compared to the index's 1% loss, making longer-term returns highly unpredictable.

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"This is quite paradoxical and difficult to understand," said Elisabeth Kashner, FactSet's director of ETF research. "They demand a lot of investing education [and] are difficult to utilize over a long period of time," she added.

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Investors must consider the high fees in addition to comprehending the underlying risks and having a strong belief in the index's direction. Investors pay an average of 1.02% in fees and expenses for leveraged and inverse products, which is much more than the 0.61% charged by themed ETFs and the 0.095% levied by an SPDR S&P 500 ETFSPY +1.60%. (SPY). Expense ratios reduce investor returns, thus investors should utilize FINRA's Fund Analyzer to calculate the impact of fees on their investment.

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Tuttle Capital Management's Matthew Tuttle, who last month filed for the Tuttle Capital 2X DBMF ETF, which mimics the daily performance of the iMGP DBi Managed Futures Strategy ETF (DBMF), believes the 0.85% management fee imposed by his fund is reasonable. This is because it provides twice the exposure for the same price as iMGP's solution, he claims. Tuttle debuted the Inverse Cramer ETF (SJIM) on Thursday, after the phenomenally successful AXS Short Innovation Daily ETF (SARK).

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The funds are not suited for all investors and are not suggested for buy-and-hold investors, according to ProShares and Direxion, which dominate the inverse and leveraged ETF sector. Both firms also feature an investor education tab.

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Tuttle places the burden on investors. "I am a MAJOR believer that investors, whether they delegate or not, need to be educated about money," he wrote in an email. "At the end of the day, these are only a few of the numerous methods available to investors to communicate their opinions...but more tools need more labor on the side of the investor."

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The Securities and Exchange Commission issued an investor alert on leveraged and inverse ETFs on February 23. "We anticipate individual investors may be perplexed about [their] performance targets," according to the announcement.

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Yet, in a world where young investors are always seeking quick methods to profit from market fluctuations, it may be difficult for some to pause and educate themselves.

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

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