Inverse and Leveraged Exchange Traded Funds

The daily results of an inverse exchange traded fund are based on the inverse daily performance of the underlying benchmark or index. A range of derivatives including index swaps and futures contracts are used to meet the objectives of the investment in order to generate results that are opposite to the underlying benchmark or index. This means that the ETF goes up when the benchmark or index goes down, and vice versa. An investment in an ETF is rather like holding short positions, or profiting from declining prices, thanks to a combination of advanced investment strategies.

The results of leveraged exchange traded fund are generated as a multiple of the daily performance return of the underlying benchmark or index. This could be a 200% return, for example. However, they will not provide the same multiple over the long term. In a single day, a leveraged ETF will generally meet the objective for the multiple of the daily performance, but if they are held for longer than a day, the returns will vary from this multiple.

A leveraged ETF works by using a number of derivatives, for example index swaps and futures contracts, in order to provide this multiple of the market exposure for the stocks in the fund. The risks are higher in a leveraged fund, as losses will also be multiplied by the same amount.

Both inverse and leveraged exchange traded funds are designed to be only held short term; which for a leveraged fund can mean just a single day. Investors looking to hold a longer term security should not consider them. Long term, a leveraged fund can drift away from its benchmark due to the effects of compounding, especially during periods of market volatility.

Investors should make sure that they understand the nature of exchange traded funds before they put any money into it, and that they are clear on the risks involved in such an investment.

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