Anyone looking over a list of the most-traded exchange-traded funds (ETFs) on a given day is probably going to notice some ETFs are predictably volatile. While most ETFs tend to feature limited daily moves because they contain hundreds (if not thousands) of stocks, some ETFs feature big swings seemingly every day. Other ETFs track a particular index but always move opposite of said index. And to add to the confusion, some ETFs swing wildly and move in the opposite direction. What gives?
The ETFs in question are commonly referred to as “Alternative ETFs,” and usually consist of inverse ETFs and/or leveraged ETFs, the former being designed to move in the opposite direction of a particular index and the latter designed to move double or triple the amount of a particular index. And, in some cases, ETFs are both inverse and leveraged, moving opposite an index at a multiple.
That basic concept is easy to understand, but the methods used to design a portfolio with asset values that change in these specific ways can be very complicated.
But, while their construction can be tricky, an average investor can find a lot of uses for alternative ETFs. Playing hunches about broad changes to the market becomes easier, and, if you’re willing to assume a bit more risk, you can increase returns.
The rise of the ETF has, at least in part, been due to its flexibility. ETFs, unlike mutual funds, trade at variable prices throughout the day, giving investors and a simple, flexible way to make bets on broad market trends.
Think the S&P 500 is going to go up this morning? Buy the SPDR S&P 500 Index ETF($SPY) at breakfast. Think it’s going to go up this afternoon? Buy the SPY at lunch. The structure of the ETF is such that it (almost always) trades at a price consistent with its underlying assets.
However, what if you want to bet that the S&P 500 is going to fall? Or what if you feel so sure the S&P is going to spike you want to double or triple your returns when it does?
Leverage is a fairly simple concept in the world of finance. At its core, it’s about getting the most potential return for your principal investment by using financial vehicles that multiply returns and losses.
For instance, the ProShares Ultra S&P 500 ETF ($SSO) is designed to double the daily returns of the S&P 500, and the UltraPro S&P 500 ETF ($UPRO) is designed to triple it. So, if you have a strong feeling that the S&P is about to go up 1 percent the next day, you can double or triple the potential returns of playing that hunch without increasing the amount you invest.
Obviously, this comes with a price: increased risk. While UPRO could give you a 3 percent return if your hunch is correct, if you’re wrong and the S&P falls by 1 percent, your losses should be 3 percent. However, for an investor with confidence, leverage is an excellent opportunity to get the most out of their principal.
An inverse ETF is just a short — a bet that an asset will fall in value. It’s a broader short than shorting just one stock, but a short just the same. So, given that you can buy and sell shares of an ETF just like you would with a stock…why wouldn’t you just short it like you would with a stock?
This question becomes especially relevant when you consider that you pay an expense ratio for an ETF (albeit a small one). More so when you consider that the companies taking the time to build and maintain inverse ETFs only do so because they expect enough demand to make the endeavor profitable. And given how many inverse ETFs are on the market, it presumably is.
However, inverse ETFs offer a few clear advantages over assuming a short position.
Advantages of Inverse ETFs
For starters, an inverse ETF is much simpler than a short. Buying and selling shares of an inverse ETF is a basic, easy-to-perform transaction (whereas short positions generally involve a more complex transaction involving contracts for borrowing shares for a set amount of time).
Secondly, inverse ETFs are much more liquid than shorts. Getting out of a short position can get complicated, often requiring that you find a buyer and negotiate a price on a secondary market. With an inverse ETF, any time you want to abandon your bearish bet, you can just sell your shares at a transparent price on a public exchange. No muss, no fuss.
Those two reasons alone are probably enough for most people, particularly retail investors, to happily fork over a small expense ratio. However, the final advantage may actually be the one that’s most important: limited liability.
The biggest issue with a classic short is that your potential losses vastly exceed your potential profits. If the stock (or ETF) goes to zero (a short position’s best-case scenario), you can double your initial investment. But if it takes off and doubles or triples in value, you can lose considerably more than your principle. The potential losses are only limited by the stock’s potential gain.
With an inverse ETF, the structure of the ETF limits your liability. Worst case scenario, your losses can’t exceed your initial investment as the ETF can’t lose more than 100 percent of its value, almost the reverse of an actual short position.
Construction of Alternative ETFs
These ideas are, of course, extremely basic. Leverage and shorts are concepts that are as old as the markets themselves, so it’s hardly surprising to see them applied to ETFs. It was really just a matter of time.
However, the precise brew of different assets required to make the value of the underlying assets change in the way desired is not so simple.
Constructing ETFs requires a lot of complex mathematics to ensure that they can maintain liquidity while still matching the performance of a target index. Even for a simple ETF like the SPY, knowing exactly how many of which shares to hold while maintaining the same proportions as your target index can actually be pretty tricky given that fund’s size is a tiny fraction of the larger index. It’s why different ETF issuers still get slight variations among their products even when they’re tracking the same index
But this gets even more complicated for alternative ETFs. Now, getting a daily performance in line with your target involves owning assets other than stocks.
Alternative Asset Classes
Leveraged ETFs rely heavily on futures contracts, in which one secures the option to purchase (or sell) a stock at a certain price in the future. The price of the contract, which one may or may not choose to execute, is much lower than the price of the actual stock, meaning it can leverage assets.
For instance, if you buy a futures contract for $1,000 that allows you to buy 10,000 shares of certain stock at $100 a share, and that stock goes to $200 a share, the value of that contract is now exponentially greater than your initial investment. That is, you can now buy $2 million worth of stock for $1 million, so the contract itself is now worth $1 million.
That’s an oversimplification, but you can still see how futures can be used to create leverage. In that transaction, the price of the stock doubles, but the contract you bought is now 1,000 times more valuable. So your $1,000 investment is now 500 times more valuable than it would be had you simply purchased 10 shares of the stock at $100 a share.
They also make use of “swaps.” At their simplest, swaps involve trading the income for two financial devices, like the yields on two different bonds. However, swaps can be written in many different ways using many different financial instruments and with many different results, ultimately resulting in them becoming exceedingly complicated.
For the people designing ETFs, this sort of flexibility comes in especially handy, but it’s often next to impossible for the average investor to understand.
Inverse ETFs also use futures contracts and swaps to build their portfolio, though ultimately less complicated. All told, the precise mathematics necessary to actually hit the price targets laid out is pretty dizzying for alternative ETFs.
Asset Value is What Matters
The thing to remember, though, is that ETFs trade based on their asset value, not their targets. The people maintaining the funds don’t always hit those targets, and the quality of the ETF will ultimately be linked to how well its managers do manage assets to meet performance expectations.
But, as complicated as this can get, it’s worth noting that the people building ETFs have this down to a science. What’s more, any ETF that routinely fails to hit its targets is probably not going to last, so when investing in an ETF with at least moderate daily volume, it’s probably a safe assumption that it will be close enough to matching its targets to satisfy anyone but the most-discerning investor.
Why Invest in Alternative ETFs
In the end, alternative ETFs can be a valued addition to any portfolio. If you’re willing to take on more risk, leveraged ETFs can give you a shot at more returns. If you feel bearish about a certain market, inverse ETFs let you play that hunch without having to research hundreds of individual companies. What’s more, if your portfolio is particularly heavy in certain assets, using leveraged and/or inverse ETF can be a great way to provide a little safety in the form of a hedge.
On the whole, ETF investors will probably get the most out of their portfolio when they understand all of their options. And alternative ETFs can be an important tool for almost any investor.
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