About Geared (Leveraged and Inverse) Funds
- Who invests in geared funds
- The investment objectives of geared funds
- Common uses for geared funds
- Geared funds' ability to achieve their target returns over periods longer than a day
- Why the performance of geared funds over time is greater or less than the multiple of index performance
- Why geared funds "reset" their exposure daily
- Holding geared funds for longer than a day
- Strategies to increase the chance of achieving returns close to the daily target over time
Who invests in geared funds
Geared funds are most appropriate for knowledgeable investors who are familiar with the benefits and risks associated with these types of products, and who have an understanding of investment concepts and practices ( Are Leveraged and Inverse Funds Right for You?). Shareholders, or their advisors, should be prepared to monitor their geared fund positions closely, as often as daily, and should use them as part of a diversified portfolio.
The investment objectives of geared funds
A leveraged ETF is designed to provide a multiple (e.g., 2x or 3x) of the return of an index or other benchmark, usually for a single day, before fees and expenses. An inverse fund is designed to provide a multiple of the opposite (e.g., -1x, -2x, -3x) of the return of an index or other benchmark, usually for a single day, before fees and expenses.
Common uses for geared funds
Geared funds are valuable tools that can be used in a variety of ways by knowledgeable investors. Some examples include:
- Using the magnified exposure of a leveraged fund to seek greater profits (of course, losses are also magnified).
- Committing less cash to target a specific level of exposure using a leveraged fund.
- Using an inverse fund to help hedge a portfolio position.
- Fine-tuning exposure (e.g., using an inverse fund to reduce exposure to a sector without selling holdings).
For more information, read our educational brochures:
Geared Investing: An introduction to leveraged and inverse funds
Geared Fund Performance: Understanding leveraged and inverse funds
Geared funds' ability to achieve their target returns over periods longer than a day
Most geared funds seek to achieve their target returns for a single day. Returns over periods beyond a day can be significantly lower or higher than the index return times the fund multiple. Nevertheless, although no one can predict future performance, Joanne Hill, PhD, and George Foster, CFA, conducted an historical study that showed a high likelihood of approximating the daily target over short periods. The shorter the period, and the lower the volatility of the underlying index, the more likely returns were to approximate the daily target. Longer and more volatile periods tended to show a greater deviation from the daily target. Using historical data, a model based on 2x the daily return of the S&P 500 index showed a 90% likelihood of producing a return between 1.75x and 2.25x the index return over any 30-day period over the last 50 years. (Models based on an index with higher volatility would have deviated more.)1
Four factors significantly affect how close daily compounded returns are to longer-term index returns times the fund's multiple: the length of the holding period, index volatility, whether the multiple is positive or inverse, and its leverage level. Longer holding periods, higher index volatility, inverse multiples and greater leverage each can lead to returns further from the multiple times the index return.
Why the performance of geared funds over time is greater or less than the multiple of index performance
Many factors can affect the performance of geared funds over time, including compounding, a universal mathematical concept that affects the returns of all investments. It is important for investors to understand how compounding affects the returns of investments under differing market conditions, including upward-trending, downward-trending and volatile markets. It is critically important that leveraged fund investors understand that the effect of compounding on geared funds is magnified, and can cause gains and losses to occur much faster, and to a greater degree, than the returns of unleveraged investments. Longer holding periods, higher index volatility, inverse multiples and greater leverage each affect the impact of compounding on returns.
Why geared funds "reset" their exposure daily
Resetting exposure in a geared fund is designed to provide constant results to investors for each day the markets are open. If these funds did not reset their exposure each day, the leverage of the funds would vary each trading day. The exposure of the fund to its benchmark, over time, could easily become very small (e.g., less than 1x) or very large (e.g., more than 5x). It is not possible for an open-end fund that does not reset its exposure each day to provide a specified, constant daily leverage level regardless of the time the investment in the fund is held.
Holding geared funds for longer than a day
The investment objective of most geared funds is to seek a multiple of an index return for a single day. Geared funds can also be used for longer periods, but the return of the fund can be significantly different than the index return times the fund multiple. Investors seeking returns for periods longer than a day that are closer to the index return times the fund multiple should monitor their investments and rebalance as needed. An investor's time horizon may be based on many factors, such as market outlook and risk tolerance. Investors may need to rebalance more frequently in funds with higher index volatility, inverse multiples and greater leverage. A rebalancing strategy will involve transaction costs and can generate tax consequences. Rebalancing does not guarantee specific future results and may result in investment losses.
Strategies to increase the chance of achieving returns close to the daily target over time
Academic research2 conducted on 2x and -2x multiples supports the idea that a basic rebalancing strategy for geared funds may help an investor to achieve returns close to 2x or -2x the index return over time. This rebalancing strategy uses a calculation to determine the amount to add to or reduce the investment in a geared fund, such that the investment exposure held is in line with the targeted return for the period. Rebalancing can be performed at fixed time periods (e.g., weekly or monthly), or it can be triggered when a specified return threshold is reached. Investors may need to rebalance more frequently in funds with higher index volatility, inverse multiples and greater leverage. A rebalancing strategy will involve transaction costs and can generate tax consequences. Rebalancing does not guarantee specific future results and may result in investment losses.
1 Study by Hill and Foster of ProShare Advisors, published in September/October 2009 issue of Journal of Indexes.
2 Path Dependence of Leveraged ETF Returns, Marco Avellanda & Stanley Zhang. New York University, May 19, 2009. Rebalancing Leveraged and Inverse Funds, Joanne M. Hill & Solomon G. Teller, Institutional Investor Journals, 8th Annual ETF Guide, October 2009.