Leverage - A Double-Edged Sword

Leveraged investing can amplify your returns, but it can also magnify your losses—a fact that is often overlooked. Careful consideration and risk management are essential when using leverage in any form.

The introduction of leveraged and inverse ETFs in 2006 marked a significant shift in asset allocation, as they made leverage accessible to all investors, including retail investors. These ETFs removed many of the complexities previously associated with leverage, like buying on margin. They have been a contributor to the growth in assets allocated to ETFs since 2020, highlighted by the 2022 surge in inflows following the introduction of leveraged singlestock ETFs (which are classified as active ETFs). More than 150 leveraged and inverse ETFs have entered the market in recent years.

It is critical to understand that leveraged and inverse ETFs were designed for tactical allocations or to adjust portfolio positioning over short periods. Meanwhile, the recent growth of these products is attributable to speculative retail investors-with holding periods being longer than their intended use.

The ratio of assets in leverage long to inverse ETFs is near an alltime high of 8.4, compared to 5.9 just a year ago, indicating continued investor optimism. However, such optimism with products like these can pose significant risks during turbulent market conditions. For instance, volatility increased in February, particularly during the last two weeks of the month. During this period, a 3x leveraged Nasdaq index ETF declined by as much as 16.6%, while the underlying index fell only 5.6%.

The use of leveraged ETFs underscores our strong conviction in active management into the more traditional categories. During volatile periods, active managers can use both bottom-up and topdown approaches to make portfolio adjustments that potentially mitigate risks and volatility and provide a smoother investment experience.

Guide to ETFs featured slide of the month (slide 23)

Keep Your Eye on the Ball

The active ETF space is broadly defined, encompassing traditional asset classes such as large-cap growth and large-cap value, as well as more esoteric exposures. Recently, there has been an influx of active ETFs that many market participants would not classify as traditional active management. Among them, inverse and leveraged ETFs, including single-stock leveraged products, have garnered significant attention—and enthusiastic inflows.