Mike Venuto on the use of Inverse ETFs for precise sector exposure

Investors can use leveraged and inverse exchange traded funds to hedge a long position against sudden turns or capture short-term trends in more volatile market conditions.

On the recent webcast, Tactical Strategies to Combat Market Volatility, Sylvia Jablonski, Managing Director and Co-Head of the Capital Markets & Institutional Strategy Team at Direxion, points out that the markets have exhibited heightened volatility, so securities are experiencing wider swings.

“We are witnessing a volatility regime change,” Jablonski said. “Average intra-year volatility has climbed to new highs.”

Michael Venuto, Co-founder & CIO of Toroso Investments, also argues that we can no longer rely on factors like quantitative easing to support a consistent market rally with limited volatility.

“The market has been irrational the last few years,” Venuto said. “Expect a return to normal volatility.”

Consequently, with the heightened volatility, more investors are beginning to pick up leveraged and inverse ETFs to play the market swings.

Jablonski explained that these leveraged and inverse ETFs try to magnify the returns of their benchmarks on a daily basis. Investors should keep in mind that most leveraged ETFs are designed to produce double or triple the performance of the underlying market on a daily basis. Consequently, when investors look at the long-term performance of a typical leveraged ETF, people may notice that the fund may not perfectly reflect their intended strategies.

A market without long interruptions and relative lack of volatility will help maintain positive gains in a leveraged ETF. Since the ETFs rebalance on a daily basis, compounding effects benefit leveraged ETFs in a consistently trending market. On the other hand, in times of increased volatility, leveraged ETF returns can fall behind their intended 2x or 3x strategies.

“Historically, the best environment for the use of leverage has been low volatility high trend,” Venuto said.

Consequently, leveraged and inverse ETF traders should closely monitor their holdings. Venuto suggests investors should “buy and adjust” and refrain from buying and holding these leveraged and inverse products, especially during volatile conditions.

Investors have utilized leveraged and inverse ETFs in a number of portfolio strategies. For example, Venuto suggests small percentage allocations in inverse leveraged options to hedge mitigate detraction from existing positions, so investors are simultaneously going long and short to hedge risk. Through leveraged and inverse ETFs, investors may help limit portfolio volatility or diminish drawdowns in the event of a steep market correction.

Jablonski also pointed to a number of popular short and long plays that have recently cropped up. For example, the Direxion 2x Daily CSI 300 China A Share ETF (NYSEArca: CHAU), which tracks the leveraged 200% position on China A-shares, and the Direxion Daily CSI 300 China A Share Bear 1x Shares (NYSEArca: CHAD), which takes the inverse or -100% performance of Chinese A-shares, have grown in popularity as U.S. investors gain greater access to the Chinese A-shares market.

The energy sector has also been gyrating after the plunge in oil prices and recent rebound in crude, especially the oil exploration and production sub-sector, which has been hardest hit during the energy sell-off. Consequently, traders have played the sudden turns in the sub-sector through the relatively new  Direxion Daily S&P Oil & Gas Exploration & Production Bear 3x Shares (NYSEArca: DRIP), which takes the -3x or -300% daily performance of the S&P Oil & Gas Exploration & Production Select Industry Index, and Direxion Daily S&P Oil & Gas Exploration & Production Bull 3x Shares (NYSEArca: GUSH), the bullish alternative to DRIP.

After plunging to a 17-year low and somewhat recovering in recent weeks, natural gas has also attracted a lot of attention. The Direxion Daily Natural Gas Related Bear 3X Shares (NSYEArca: GASX) has previously been a popular bet to capitalize on the misfortunes in the natgas market, but the long Direxion Daily Natural Gas Related Bull 3X (NYSEArca: GASL) has quickly gained traction as investors rode the recent rally.

Looking ahead, the Direxion Daily 20-Year Treasury Bear 3X (NYSEArca: TMV), which takes the inverse -3x or -300% daily performance of the NYSE 20 Year Plus Treasury Bond Index, could also be a great way to play a rising interest rate environment as the Federal Reserve contemplates higher rates.

Financial advisors who are interested in learning more about implementing leveraged and inverse ETF strategies can listen to the webcast here on demand.