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Leveraged and inverse products can be extremely risky. In 2018, Credit Suisse’s US$1.6-billion short volatility XIV ETN was killed off after collapsing 90 per cent in one day.Spencer Platt/Getty Images

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Investors have poured record sums into high-risk leveraged funds this year in spite of the collapse in financial markets.

The funds, designed to magnify any market gains, also deepen any losses if asset prices fall, meaning many investors are likely to have been left badly out of pocket as stock markets have tumbled this year.

Globally, investors pumped a net US$28.3-billion into leveraged and inverse exchange-traded funds (ETFs) in the first nine months of the year, according to data from Morningstar Direct, equivalent to 5.4 per cent of all purchases of ETFs.

That’s more than double the 2021 full-year tally of US$13.2-billion, which accounted for just 1.1 per cent of last year’s bumper ETF flows, and comfortably above the full-year record of US$17-billion set in 2008.

Morningstar does not have a global breakdown of the asset split between leveraged long funds – designed to deliver a multiple of any daily rise by a stock or a basket of stocks, but potentially ruinous if prices fall sharply – and inverse ones, which are a bet on falling prices.

However, its data for the U.S. show that the vast majority of the money has been siphoned into leveraged long vehicles, which attracted US$18.5-billion in the 12 months ended Sept. 30, 4.6 per cent of all flows to U.S. ETFs, three times the US$6.2-billion netted by inverse funds.

The resultant value destruction is evident in some vehicles. Direxion Daily Semiconductor Bull 3x Shares SOXL-A, has been the second-most popular leveraged or inverse ETF in the world this year, taking in a net US$6.3-billion in the first nine months, according to Morningstar. Yet, its total assets had dwindled to just US$3.1-billion as of Sept. 30.

Similarly, MicroSectors Solactive FANG & Innovation 3x Leveraged ETN BULZ-A had net inflows of US$504-million over the period, while its market capitalization fell to US$208-million.

“There are clearly those with a bullish sentiment out there,” says Kenneth Lamont, senior fund analyst for passive strategies at Morningstar Inc.

“There is an argument that the tech bubble has burst and we are down to more realistic valuations, and that there is some value out there. A targeted rebound bet may be sensible within that context,” says Mr. Lamont, even if he personally found it “difficult to be overly optimistic in the current environment” given the backdrop of rapid rises in interest rates by historical standards.

Leveraged and inverse products can be extremely risky. In 2018, Credit Suisse’s US$1.6-billion short volatility XIV ETN was killed off after collapsing 90 per cent in one day.

More recently, in March 2020, WisdomTree Investments Inc. had to close its three times leveraged oil products after their value was wiped out by COVID-19-induced market volatility.

Nevertheless, Nate Geraci, president of The ETF Store, a Kansas-based investment advisor, attributed the sharp pick-up in the usage of leveraged and inverse funds to this year’s rise in market volatility.

“When markets turn particularly volatile – as they have in 2022 – the daily moves in leveraged ETFs are even more pronounced and attract tactical traders seeking a convenient way to quickly capitalize,” he says.

Although Mr. Geraci says “the vast majority of investors shouldn’t touch leveraged ETFs with a ten-foot pole,” these products could be useful for more sophisticated traders seeking to take advantage of sharp market swings.

“[The year] 2022 has provided the perfect environment for enticing traders to use these high-octane tools – which is why we’re seeing record flows,” he adds.

Deborah Fuhr, chief executive officer of ETFGI LLP, a London-based consultancy, says that last year, when markets were rising, people were happy to buy mainstream equity products, but that this year’s more challenging environment had led some investors to seek alternatives.

She also attributes the jump in trading to rapid expansion in the availability of single-stock leveraged and inverse ETFs.

These vehicles – based on the movements of individual stock prices, rather than baskets of securities, rendering them riskier still – have been permitted in Europe since 2018 but were only approved by regulators in the U.S. in July.

“These products are new and [based] on securities that many people will know,” such as Apple Inc. AAPL-Q and Tesla Inc. TSLA-Q, Ms. Fuhr says. “Many people tend to have some money that they will try out on new things.”

But she says the U.S. Securities and Exchange Commission was becoming “concerned about them,” potentially casting a cloud over their future.

Some popular inverse products have delivered strong returns during 2022′s bear market, however.

Although these ETFs are not designed to be held for extended periods, anyone who has had ProShares UltraPro Short QQQ ETF SQQQ-Q since the start of the year would have seen a 103 per cent return as of Nov. 9.

The fund, which seeks to deliver a daily return, before fees and expenses, that corresponds to three times the inverse of the technology-heavy Nasdaq 100 index, saw net inflows of US$610-million in the first nine months of the year.

Likewise, ProShares UltraPro Short S&P 500 SPXU-A, which has similar exposure to the broader U.S. stock market, has taken in US$537-million and returned 51 per cent over the same period.

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