Leveraged/Inverse ETFs to Hedge Against Potential Risks Ahead

As the U.S. prepares for potential risks that could topple the markets’ push toward new highs, investors may look toward leveraged and inverse exchange traded funds to hedge against potential volatility.

On the recent webcast, Smarter Beta: Tricks of the Trade for Leveraged ETFs, Sylvia Jablonski, Managing Director and Head of Capital Markets & Institutional Strategy Team at Direxion, pointed to hot button topics that have shaken traditional asset categories, such as the gold swings this year, rising uncertainty surrounding the upcoming presidential election and positioning in a post-Brexit environment.

Consequently, more traders are looking at alternative investment options like leveraged and inverse ETFs to hedge against the swings. However, potential investors should note that these geared ETFs are not like traditional beta-index funds.

Leveraged and inverse ETFs utilize derivatives to achieve their exponential or inverse returns. The derivatives include instruments like swap agreements, futures and forward contracts, and put and call options.

Potential traders should keep in mind that these leveraged ETFs are designed to produce double or triple the performance of the underlying market on a daily basis. Consequently, when investors look at the long-term performance of a typical leveraged ETF, people may notice that the funds do not perfectly reflect their intended strategies.

A strong bull market without long interruptions and relatively low volatility help maintain positive gains in the leveraged ETF. Since the ETFs rebalance on a daily basis, the compounding effect benefits leveraged ETFs in an upward-trending market. In an upward-trending market, compounding can generate longer-term returns that are greater than the sum of the individual daily returns. Similarly, in a downward-trending market, compounding can generate longer-term returns that are less negative than the sum of the individual daily returns.

On the other hand, in times of increased volatility, leveraged ETF returns can fall behind their intended 2x or 3x strategies. Over the long-term or during periods of intense volatility, compounding can generate long-term returns that are less than the sum of the individual daily returns.

Consequently, most investors may utilize leveraged and inverse ETFs to execute opportunistic short-term trades, generate portable alpha, hedge market turns, preserve capital or capture volatility.

Investors and advisors often allocate a good segment of their portfolios to tactical trades to pounce on short-term opportunities. In a survey of advisors on the webcast, 29% of respondents showed they held 11% to 25% of their portfolio in tactical investments and 28% revealed they held 1% to 10% in tactical positions.

Looking ahead, Jablonski pointed to a number of potential opportunities. The repatriation policy will have an effect on S&P 500 ETFs, the Affordable Care Act and Pharma Pricing regulations affect healthcare, Wall Street regulation affect financials, minimum wage affects retail and homebuilders, foreign trade agreements affect china and international markets, Federal Reserve action affect Treasuries and oil regulation affect the energy sector.

For example, the Fed’s recent decision to stand pat on interest rates helped the Direxion Daily Gold Miners Index Bull 3X Shares (NYSEArca: NUGT) surge but dragged on the Direxion Daily Gold Miners Index Bear 3X Shares (NYSEArca: DUST) as a normalizing interest rate environment negatively affects gold prices. On the other hand, if the Fed hikes interest rates, NUGT would have plunged and DUST would have jumped.

When trading ETFs, investors may be wary of less liquid funds with perceived low volume trading action. However, Andrew McOrmond, Managing Director of ETF Trading Solutions at WallachBeth Capital, tried to shed light on how ETF trades. Specifically, McOrmond highlighted the fact that ETF’s true liquidity is represented by its underlying assets.

An ETF is only as liquid as its underlying holdings. If a trader sees low volume trades on an ETF, one can work with his or her brokerage platform and even an alternative liquidity provider, like WallachBeth, to execute a large ETF order without negatively impacting market prices.

Financial advisors who are interested in learning more about leveraged and inverse ETF strategies can watch the webcast here on demand.

This article was provided by our partners at ETFTrends.