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Does investing in leveraged ETFs mean opening Pandora's box?

Part 4
Does investing in leveraged ETFs mean opening Pandora's box? (Part 4 of 8)

Inverse and leveraged ETFs and financial institutions like Citibank

Inverse ETFs

Inverse ETFs are constructed to profit from a falling market. Inverse ETFs achieve this by taking short positions and using various derivatives. Due to their characteristics, they’re also known as “Short ETFs” or “Bear ETFs.” Investors who are looking to take short positions on an index but who don’t want to hold a margin account with a broker can invest in inverse ETFs.

The Proshares Short S&P500 (SH) seeks daily investment returns, before feed and expenses, that correspond to the inverse of the daily returns on the S&P500 (SPY). SH does so by getting into swap arrangements with financial institutions such as Goldman Sachs (GS) and Citibank (C).

SPY vs SHEnlarge Graph

Leveraged ETFs

While traditional ETFs seek to mirror the performance of an underlying index, leveraged ETFs seek to deliver multiples of the daily returns of the benchmark index that they track. For example, the ProShares Ultra S&P500 (SSO) seeks to achieve twice the daily returns of the S&P500, before fees and expenses. Just like inverse ETFs, leveraged ETFs try to achieve this by entering into derivatives with counterparties—typically financial institutions like Goldman Sachs (GS) and Citibank (C). Besides using derivatives, leveraged ETFs also rely on borrowing to deliver the target daily returns.

We’ve emphasized the word “daily” above because of the daily reset arrangement, which we’ll discuss in the subsequent parts of the series.

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