Advanced ETF strategies: leveraged, inverse, and synthetic ETFs

In the previous article, we discussed how ETFs can be used to generate a reliable income stream. Now, let's explore this topic further.

While standard ETFs provide excellent tools for long-term investors, the ETF universe also includes more complex instruments designed for sophisticated trading strategies. These advanced ETFs can serve specific purposes in the hands of knowledgeable investors but come with significantly higher risks that Saxo Bank clients should thoroughly understand before considering their use.

Leveraged ETFs: amplified exposure

Leveraged ETFs aim to deliver multiples (typically 2x or 3x) of their underlying index's daily return using derivatives and debt.

How they work:
A 2x leveraged S&P 500 ETF uses financial engineering to deliver twice the daily return of the S&P 500 index. If the S&P 500 rises 1% in a day, the 2x ETF aims to rise 2%. Conversely, if the index falls 1%, the ETF would fall 2%.

Critical limitation:
Leveraged ETFs are designed to achieve their stated multiple for a single day only. Due to the mathematics of compounding, they can significantly deviate from their target multiple over longer periods, even if the underlying index ends up exactly where it started.

Real-world example:
Consider a 3x leveraged ETF tracking an index that rises 10% one day and falls 10% the next:

• Day 1: index +10%, ETF +30%
• Day 2: index -10%, ETF -30%

Starting with €10,000:

• Index: €10,000 → €11,000 → €9,900 (1% loss)
• 3x ETF: €10,000 → €13,000 → €9,100 (9% loss)

This "volatility decay" means leveraged ETFs almost always underperform their stated multiple over extended periods, making them unsuitable for buy-and-hold investors.

Inverse ETFs: betting on declines

Inverse (or "short") ETFs are designed to move in the opposite direction of their target index, rising when the market falls and falling when the market rises.

How they work:
Inverse ETFs use derivatives like swaps and futures contracts to create a position that generates returns opposite to their benchmark index. A -1x inverse S&P 500 ETF aims to rise 1% when the S&P 500 falls 1%.

Typical usage:
These products are primarily used as short-term hedging tools to protect against market declines without selling existing positions or using options strategies.

Real-world example:
An investor with €100,000 in broad market ETFs concerned about a potential short-term market correction might invest €10,000 in an inverse ETF as a temporary hedge. If the market falls 5%, their core portfolio would lose approximately €5,000, but the inverse ETF would gain approximately €500, partially offsetting the loss.

Synthetic ETFs: indirect exposure

Unlike physical ETFs that directly own the underlying assets they track, synthetic ETFs use swap agreements with counterparties to replicate index performance.

How they work:
The ETF provider enters into a swap contract with a financial institution (usually an investment bank). The counterparty agrees to pay the ETF the exact return of the index it tracks in exchange for a fee.

Key risk: counterparty exposure
If the swap counterparty defaults or fails to honor its obligations, the ETF could face significant losses unrelated to the performance of the underlying index. While regulations require collateral to mitigate this risk, it remains a fundamental concern with synthetic structures.

Real-world example:
A synthetic ETF tracking an emerging market index might use swaps instead of directly owning hundreds of less liquid stocks. This approach can reduce tracking error and costs but introduces counterparty risk that doesn't exist in physically replicated ETFs.

Who should consider these products?

These advanced ETF types are generally appropriate only for:

• Professional traders
• Sophisticated investors with specific short-term objectives
• Investors who actively monitor positions daily
• Those who fully understand the complex mechanics and risks involved

Critical risk factors

1. Compounding effects: daily rebalancing in leveraged and inverse ETFs leads to decay in choppy markets
2. Counterparty risk: synthetic structures depend on the financial health of swap providers
3. Higher costs: these complex products typically carry expense ratios 2–5 times higher than standard ETFs
4. Liquidity concerns: some advanced ETFs have lower trading volumes, leading to wider spreads
5. Regulatory scrutiny: financial authorities continue to examine these products due to their complexity and potential for misuse

For most Saxo Bank clients focused on long-term wealth building, standard ETFs remain the most appropriate tools. Advanced ETF products should be approached with extreme caution and used only for specific short-term strategies by investors who thoroughly understand their mechanics and limitations.

In the next article, we will look at the key risks involved in ETF investing and how to manage them effectively.