What Is a Leveraged ETF?
A leveraged ETF is an exchange traded fund (ETF) that uses leverage to enhance returns. The leverage is typically created by trading put and call options on the fund.
An ETF is a portfolio of securities, usually stocks and/or bonds, that is itself securitized to create a single investment: shares of the investment portfolio are traded on an exchange, just like shares of stock, between investors. While this sounds a lot like a mutual fund, there are important differences: ETFs are much more liquid, their fees are almost always lower, and tax consequences from trading are less common.
An ETF usually tracks an index, that is, the fund holds the same securities that you would find in an index such as the S&P 500 Index, or the US Energy Sector, or small cap tech stocks. In that way, it allows an investor to make one investment (in the ETF) and hold a diversified portfolio of an index representing a corporate sector (industry), region, or size. Fixed income or bond ETFs work much the same way.
Leveraged ETFs are usually constructed so the leverage will produce a multiple of an index’s return. For example, “2x S&P 500 ETF” is a leveraged ETF designed to produce twice the gain (or loss) of the S&P 500 Index’s daily gain (or loss).
An inverse leveraged ETF is designed to produce the opposite performance. For example, an “inverse 2x S&P 500 ETF” is designed to produce a gain equal to twice the loss of the S&P 500 on any given day, or a loss equal to twice the daily gain.
How Do Leveraged ETFs Work?
Leveraged ETFs work by adding leverage to an investment in an ETF. This is done at the fund level, by the fund’s management, so investors that invest in a leveraged ETF are investing in the management’s use of leverage. Leveraged ETFs are “actively managed” ETFs.
Leveraged ETFs usually do not use conventional debt, like loans or margin to enhance returns, but instead they use derivatives, based on the underlying index. The derivatives are usually call or put options that enable the fund managers to make short-term bets on whether the index will go up or down. The investor can bet on the index by investing in the leveraged ETF; the investor’s return is the gain or loss on the index plus the gain or loss on the bet.
Here is an example: let’s say you invest $100 in a double-leveraged (2x) S&P 500 ETF. If the S&P 500 goes up by 10%, your ETF shares go up by 20% and are now worth $120. The ETF’s leverage has magnified your gain compared to the index’s gain.
If, instead, the S&P 500 goes down by 10%, your ETF shares go down by 20% and are now worth $80. To recover its losses, the S&P 500 would have to go up by 11%. If that happened, your leveraged ETF shares would go up by 22% but then they would be worth only $97.60. The ETF’s leverage has magnified your loss compared to the index’s loss.To recover your full value, your leveraged ETF shares would have to go up more than twice the gain of the index, or in this case 25%.
Leveraged ETF Pros and Cons
As with all investments, there are pros and cons to investing in leveraged ETFs.
Pros
More risk means greater potential return. If you are betting on an index and your bet pays off, your gains will be magnified by the leveraged ETF.
Like all ETFs, leveraged ETFs allow for a more liquid investment in an index than mutual funds.
Cons
More risk means greater potential losses. If you are betting on an index and your bet does not pay off--the index moves against you--your losses will be magnified by the leveraged ETF.
Losses get magnified, and fast, especially during periods when the index returns are volatile. For that reason, leveraged ETFs are not appropriate as a long-term investment.
Fund fees are higher, since more management is involved in creating and maintaining the leverage. The leverage positions are short-term, increasing turnover and fees.
Some leveraged ETFs do not trade often, and therefore are not as liquid as unleveraged ETFs. This also adds to trading costs as bid/ask spreads are typically wider, leading to less preferable pricing.
How to Trade Leveraged ETFs
Leveraged ETFs can be traded through any individual brokerage account that accommodates trading ETFs, just like trading (unleveraged) ETFs, mutual funds, stocks, or bonds. Of course, trading is subject to the conditions of the brokerage account, such as any minimum balance requirements, margin, or settlement conditions or restrictions. Check out the best online brokers in the market and find the right one for you.
Leveraged ETFs are usually used by experienced investors to make short-term bets on the direction of an index. Since losses are magnified and can be difficult to “make up,” leveraged ETFs are not recommended as long-term investments.
Leveraged ETF Examples
Here are some examples of popular leveraged ETFs.
Leveraged ETF | Ticker | What it Offers |
ProShares Ultra Pro Short QQQ | SQQQ | 3x downside exposure to the large-cap, tech dominated NASDAQ 100 |
ProShares Ultra Pro Short Dow 30 | SDOW | 3x downside exposure to the Dow Jones Industrial Average (DJIA) |
Direxion Daily Semiconductor Bull 3x Shares | SOXL | 3x upside exposure to semiconductor sector |
Direxion Daily Small-Cap Bull 3x Shares | TNA | 3x upside exposure to the Russell 2000 Index |
Direxion Daily Small-Cap Bear 3x Shares | TZA | 3x downside exposure to the Russell 2000 Index |
Direxion Daily S&P 500 Bull 3x Shares | SPXL | 3x exposure to the S&P 500 Index |
SUMMARY
Investing in leveraged ETFs is a way to make short-term bets on the direction of an index and to earn enhanced returns. However, losses are magnified as well as gains, so these investments are more appropriate as short-term trading vehicles for savvy investors with significant experience.
References:
https://www.bankrate.com/investing/best-leveraged-etfs/
https://seekingalpha.com/article/4464730-pricing-of-leveraged-etf-decay-a-different-approach
