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What are inverse and leveraged ETFs?

Inverse ETFs structures are designed to achieve daily investment results that are the opposite or inverse daily performance of their underlying index, commodity, currency or benchmark. Inverse ETFs use a variety of derivatives such as futures contracts and index swap contracts in an attempt to produce a daily result that is opposite and proportional of the underlying benchmark.

For example, if an inverse ETF is based on the S&P/TSX 60 Index’s movement, then if the TSX 60 Index declines by 5.0%, during the trading day, then the Inverse ETF is designed to increase in value by 5.0%, and vice versa. These ETFs are typically used as a short-term trading vehicle because they settle and re-establish their futures contracts and index swaps daily. Given the nature of these contracts and the investment fees, the Inverse ETFs will have a larger tracking error. 

Leveraged ETFs attempt to achieve daily investment results to provide a multiple (usually 200% or 300%) of the daily performance of an underlying index or benchmark. Because these ETFs settle all trades daily and they use leverage, they are not intended as Buy and Hold investments. Again Leverage ETFs are better viewed as a trading vehicle. Over time the leverage aspect and the daily settlement structure increases the tracking error when compared to the underlying index or benchmark.

There are also Leveraged Inverse ETFs, which are again better suited to those wishing to trade the underlying index or benchmark on a short-term basis. The returns on leveraged ETFs over time can drift significantly from its benchmark due to the effects of compounding, especially during periods of market volatility.

To achieve their stated investment objectives, leveraged ETFs use a variety of derivatives such as futures contracts and index swaps to provide a multiple of the market exposures. Using leverage magnifies the potential gains and potential losses from an investment in such ETFs. 

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