By Emily Doak, Managing Director of ETF Research for Charles Schwab Investment Advisory.

Leveraged and inverse ETPs: Going, going, gone?

The record volatility of 2020 has been accompanied by a higher than usual number of exchange-traded product closures, especially among leveraged and inverse products.

According to data from FactSet, 91 ETPs were closed in Q1, including over 30 which promised either leveraged or inverse exposure to an index.

At Schwab, we continue to believe that leveraged and inverse ETPs are not suitable for most investors. However, if you were holding one of these products when it closed, or are still holding one that was delisted, you might be wondering if you’ll get your money back. Well, it depends.

Terms & definitions

Let’s first review the terminology. ETP is the blanket term that covers both exchange-traded funds and exchange-traded notes. Although these products have similar sounding names, they’re actually quite different.

An ETF is an entity that owns a basket of securities, such as stocks, bonds, or commodities. ETFs are legally separate from the companies that manage them. They’re typically structured as “investment companies,” “limited partnerships,” or “trusts.”

ETNs are not independent pools of securities. Instead, an ETN is an unsecured note issued by a financial institution, which promises to pay ETN holders the return on some index (or multiple of that index) over a certain period of time. There are also differences when these two types of products close.

Closings

The process for closing an ETF is fairly straightforward. The ETF’s manager will announce a date at which the fund will no longer accept creation orders (in other words, no new shares of the ETF will be issued).

Next, the fund will be delisted from its exchange (halting secondary market trading), and the manager will begin the process of liquidating the fund’s assets.

Finally, cash is distributed to shareholders, usually within a week of delisting. Of course, investors who find themselves holding an ETF that has announced its forthcoming closure can always sell their shares before the delisting date, instead of waiting for the final distribution.

ETNs are more complicated to shutter, and the closure process will depend heavily on what was written into the note’s prospectus when it was first issued. One way to close an ETN is to call the note and return its value to investors minus fees. This is known as “accelerated redemption.”

Accelerated redemptions can be either elective or mandatory. Elective redemptions occur when the note’s issuer chooses to call the note before its scheduled termination. Mandatory redemptions occur when the note triggers a condition that was predetermined by its prospectus, such as the value of the note declining below a specified threshold.

However, some ETNs have no provisions in their prospectuses to allow for accelerated redemption. In this case, the ETN is simply delisted from its national exchange, and investors are forced to either wait for the note’s scheduled maturity (which could be decades away) or try trading it in the over-the-counter market, generally at a big discount.

If you need to find information about an ETF or ETN that has announced its closure, a good place to begin is the issuer’s website. Most issuers do a good job of describing the closing process and providing key dates on either the product page or in the news/announcements section.

Fair warning

Nevertheless, investors should keep in mind that it’s not uncommon for leveraged and inverse ETPs to close as a result of losing nearly all of their assets. For example, ProShares UltraPro 3x Crude Oil ETF (OILU US) closed on March 27, 2020, with a net asset value of $0.21 after beginning the month of March with a NAV of $9.29.

Likewise, UBS ETRACS Mthly Py 2xLvg Mortg REIT ETN (MORL US) closed on March 18, 2020, with an indicative value of $0.11. For investors who purchased the note on March 4, 2020, at $13.63—this represented a 99% loss.

Due to potential confusion about leveraged and inverse exchange-traded funds’ performance objectives, the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) issued a joint warning in 2009 about the risks of these products for buy-and-hold investors—including the possibility of big losses.

Displaying remarkable prescience, the joint alert contained another important warning that might have been overlooked at the time, but seems especially relevant today: “There is always a risk that not every leveraged or inverse ETF will meet its stated objective on any given trading day.”

Since most leveraged and inverse products gain exposure to the underlying index through specialized derivatives contracts that are negotiated with large banks or other financial institutions—known as “total return swaps”—they rely on the existence of a counterparty who will take on the other side of the trade, for a fee.

In some market conditions, the cost of obtaining exposure via swaps may increase beyond what the manager is willing or able to pay; the manager will then be forced to either reduce the leverage ratio or close the product.

Research has shown that when the ETP promises a large absolute leverage factor (i.e., -2x or +3x) or tracks a highly volatile index, leveraged and inverse ETPs are at higher risk of not providing their promised level of exposure.

Source: Charles Schwab.

Some observers are worried that leveraged and inverse ETPs may pose risks to the entire financial system—or at least to the markets in which they operate. While it is possible (although rare) for a leveraged or inverse ETP to influence prices in the underlying assets of the index it tracks, we’ve also seen issuers respond to market conditions and higher swap costs by taking the following actions:

• Closing the ETP (or temporarily suspending creations)
• Decreasing the leverage factor
• Changing or modifying the index tracked by the ETP

As a result, one-directional pressure on the prices of the underlying assets is reduced. Knowing that markets are in control of leveraged and inverse ETPs, rather than the other way around, should provide some comfort to the worried observers.

Bottom line

Investors in leveraged and inverse ETPs may find that there isn’t much to recover when their leveraged or inverse product closes. However, if there is value remaining in the investment, investors should first confirm whether the product is an ETF or an ETN and then check the issuer’s website for important dates and details.

ETN investors should be prepared to act quickly if the note is being delisted without accelerated redemption, since trading the ETN on the national exchange before its delisting date may offer a better experience than trading over-the-counter.

And, as with all investments, it is important to read the prospectus and fully understand the product’s investment objectives, investment strategies, risks, and costs.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)