Complex ETFs offering big rewards amp up market risks

From single-stock to inverse exchange-traded funds, firms have been marketing more complex strategies offering potentially monster gains to individual investors.

However, the recent market volatility may be intensifying the risk of losses.

Openinterest.Pro co-founder and chief strategist Mike Khouw warns when markets turn lower or swing sharply, these leveraged products can underperform the assets they track and struggle.

“Leverage is a very appealing thing when the only things you’ve noticed over the course of the last couple of years is that prices are rising,” the CNBC contributor told “ETF Edge” this week. “But having leverage is a double-edged sword.”

The reason: leverage often adds another layer of risk. Khouw notes many lightly leverged ETFs use tools such as total return swaps or options to deliver the extra exposure they advertise. To maintain that leverage, portfolio managers must regularly adjust their positions, and it get tricky in a choppy market.

Khouw, whose firm focuses on options-focused research and analytics, said the explosion of weekly and even daily options has made the market so time-sensitive and complex that most retail investors can’t realistically manage these trades on their own. 

“Finding a product where essentially someone else can handle some of that for you … democratizes those products. That’s the good news,” Khouw said. “The bad news is that sometimes the investors’ education or understanding of both options and some of these products isn’t keeping pace with their rapid development and issuance.”

Nate Geraci, president of NovaDius Wealth Management, sees two main trends behind the growth of inverse and leveraged products in the complex ETF space.

First, he sees a change in retail investor mindset. They are chasing products that advertise much bigger, “astronomical” returns — even if they do not fully grasp the risks.

The second trend is increased competition in the ETF market, according to Geraci, whose firm rebranded to NovaDius Wealth Management from The ETF Store earlier this year.

“There’s essentially an arms race among ETF issuers,” said Geraci, who added it also opens up the possibility for “significant losses.”