What Is a Leveraged ETF and How Do They Work?

What Is a Leveraged ETF?

As usual, an ETF tracks an underlying index or investment product in order to emulate performance. The goal is not to outperform the correlating investment, but to give investors a beneficial way to mimic price.

Leveraged ETFs go a bit further. They do want to outperform the index or commodity they track. Generally, a leveraged ETF is designed to provide 2–3 times the return of the correlating asset. So if the tracked index rises 1%, a 2x leveraged ETF wants to create a 2% return on investment (ROI). There are also inverse leveraged ETFs, which offer multiple positive returns if an index declines in value. They work the same as normal inverse ETFs; they are just designed for returns of 2–3 times the opposite of the index.

Video

Rising market data grid—market up 10% daily for 10 days

Days elapsed Daily market performance Expected index level Expected 2x leveraged long ETF level Daily ETF performance
0.00% 100.00 100.00  
1 10.00% 110.00 120.00 20.00%
2 10.00% 121.00 144.00 20.00%
3 10.00% 133.10 172.80 20.00%
4 10.00% 146.41 207.36 20.00%
5 10.00% 161.05 248.83 20.00%
6 10.00% 177.16 298.60 20.00%
7 10.00% 194.87 358.32 20.00%
8 10.00% 214.36 429.98 20.00%
9 10.00% 235.79 515.98 20.00%
10 10.00% 259.37 619.17 20.00%
10-day cumulative change 159.00% 519.00%    

In the next chart, you can see the grid depicting the opposite event. In this situation the market drops 10% per day for 10 days straight. In this example, as the index drops from 100 to 90, producing a 10% move of 10 points, on day 2 the down move will be 10% and only 9 points. The daily compounding of the leveraged ETFs will magnify this effect. While the ETF will be achieving a negative 20% move on a daily basis over the longer-term horizon, the compounding will result in a much less significant move downward than 2 times the index drop. In this example, with the index down 65% over the 10-day period, the ETF is down only 89% (rather than 130%) because it was losing progressively less in notional points every day.

Pros Cons of Leveraged ETFs

There are potential benefits of investing in leveraged ETFs but there are also some disadvantages that investors should know about before buying shares.

Pros of Leveraged ETFs

  • Alternative to derivatives: Leveraged ETFs offer indirect access to financial derivatives, such as options and futures contracts, that may otherwise be inaccessible to everyday investors, or more expensive to trade.
  • Easy access: Like traditional ETFs, shares of leveraged ETFs trade in the open market like stocks.
  • Potential for outsized returns: Leveraged ETFs amplify the daily returns of an underlying benchmark index, providing the potential for larger gains than traditional ETFs.

Cons of Leveraged ETFs

  • Excessive market risk: The potential for outsized gains brings with it the potential for outsized declines in value. Unless the market is constantly moving in the same direction, which is not typical, leveraged ETFs will generally see value erosion over time.
  • High fees: Leveraged ETFs cost more to manage than traditional ETFs because of the additional expenses associated with trading financial derivatives.
  • Poor long-term holdings: Since leveraged ETFs are intended to amplify the daily returns of a benchmark index, they should only be used as short-term holdings. Their long-term returns do not track the index, performance erodes over time, and they do not amplify returns in equal measure.

Warning: Leveraged ETFs are inherently more risky than traditional ETFs. While investors may receive amplified returns with leveraged ETFs, the declines in value are also amplified. Furthermore, due to the way they are constructed, these instruments usually experience value erosion over time. Because of these unique qualities, leveraged ETFs are best used by short-term traders and are not generally appropriate as long-term investment holdings.

The Costs of Leverage

Along with management and transaction fee expenses, there can be other costs involved with leveraged exchange-traded funds. Leveraged ETFs have higher fees than non-leveraged ETFs because premiums need to be paid to buy the options contracts as well as the cost of borrowing—or margining. Many leveraged ETFs have expense ratios of 1% or more.

Despite the high expense ratios associated with leveraged ETFs, these funds are often less expensive than other forms of margin. Trading on margin involves a broker lending money to a customer so that the borrower can purchase stocks or other securities with the securities held as collateral for the loan. The broker also charges an interest rate for the margin loan.

For example, short selling, which involves borrowing shares from a broker to bet on a downward move, can carry fees of 3% or more on the amount borrowed. The use of margin to buy stock can become similarly expensive, and can result in margin calls should the position begin losing money. A margin call happens when a broker asks for more money to shore up the account if the collateral securities lose value.

AUM Leaderboard

Leveraged Equities and all other leveraged asset classes are ranked based on their aggregate assets under management (AUM) for all the U.S.-listed ETFs that are classified by ETF Database as having leveraged exposure to a given asset class. All values are in U.S. dollars.

Leveraged ETFs: What they are and how they work

Most investors use ETFs as a low-cost option to diversify and mimic the performance of a broad index like the S&P 500. So, if the benchmark is up 1 percent, the SPDR S&P 500 ETF Trust (SPY) will also rise about 1 percent.

With leveraged exchange-traded funds (leveraged ETFs), the results are exponentially magnified as financial derivatives react differently to market changes.

For example, when the S&P 500 is up 1 percent, a leveraged ETF tracking the index could rise 2 percent or even 3 percent. It all depends on the magnitude of leverage used and how it connects to the news causing the move.

While that might sound tempting, potential losses can be just as pronounced. Financial derivatives, like other exotic market products, react differently to negative news. Using the hypothetical example above, when the stock market drops 2 percent, a triple-leveraged ETF will plunge around 6 percent, depending on the underlying assets.

Dividend Leaderboard

Leveraged Equities and all other leveraged asset classes are ranked based on their AUM-weighted average dividend yield for all the U.S.-listed ETFs that are classified by ETF Database as having leveraged exposure to a given asset class.

Portfolio Management With Leveraged ETFs

Every ETF investment strategy should be evaluated on a case-by-case basis. Using leveraged ETFs is an advanced investment strategy and should not be taken lightly. While ETFs offer many benefits, and leveraged ETFs could possibly increase returns, there are risks involved. You should only attempt to trade these securities with a lot of prior experience—and the help of a good broker.

To get an initial feel for this market, pay attention to how some leveraged ETFs react to market conditions and conduct thorough research. A few examples to follow include:

  • QLD–ProShares Ultra QQQ ETF
  • DDM–ProShares Ultra Dow30 ETF
  • SSO–ProShares Ultra S&P500 ETF

Real-Life Examples

The following two real-life examples illustrate how returns on a leveraged or inverse ETF over longer periods can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.

  • Between December 1, 2008, and April 30, 2009, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index’s daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index’s daily return fell by 25 percent.
  • During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53 percent, while the underlying index actually gained around 8 percent. An ETF seeking to deliver three times the inverse of the index’s daily return declined by 90 percent over the same period.

How can this apparent breakdown between longer term index returns and ETF returns happen? Here’s a hypothetical example: let’s say that on Day 1, an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 20 percent on that day and have an ending value of $80. On Day 2, if the index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 20 percent, which means the ETF would have a value of $96. On both days, the leveraged ETF did exactly what it was supposed to do – it produced daily returns that were two times the daily index returns. But let’s look at the results over the 2 day period: the index lost 1 percent (it fell from 100 to 99) while the 2x leveraged ETF lost 4 percent (it fell from $100 to $96). That means that over the two day period, the ETF’s negative returns were 4 times as much as the two-day return of the index instead of 2 times the return.

What does leverage mean?

Uninformed investors might assume that the leverage returns are generated on a continuous basis, so that if an underlying index is up 5% for a month, the double-leveraged ETF will be up 10% for the same month; if the index is up 10% for 6 months, the ETF will be up 20%, and so forth. That is absolutely not the case. The leverage is determined on a daily basis and the returns for any other period usually will not be double or triple the underlying index.

In order for the leveraged funds to achieve appropriate levels of assets so they can provide their implied leverage, they have to rebalance daily. In the case of an ETF providing long 2-times leveraged exposure, they would typically attain exposure to a notional set of assets equal to 2 times their NAV. An example would be an ETF that takes in 100 units in assets that does a swap with a counterparty to provide exposure to 200 units in performing assets. The rebalancing activity of these funds will almost always be in the same direction as the market.

In essence, a leveraged ETF is essentially marked to market every night. It starts with a clean slate the next day, almost as if the previous day had not existed. This process produces daily leverage results. However, over time, the compounding of this reset can potentially vary the performance of the fund versus its underlying benchmark. This can result in either greater or lesser degrees of final leverage over individual holding periods.

Leveraged ETFs Explained

ETFs are funds that contain a basket of securities that are from the index that they track. For example, ETFs that track the S&P 500 Index will contain the 500 stocks in the S&P. Typically, if the S&P moves 1%, the ETF will also move by 1%.

A leveraged ETF that tracks the S&P might use financial products and debt that magnify each 1% gain in the S&P to a 2% or 3% gain. The extent of the gain is contingent on the amount of leverage used in the ETF. Leveraging is an investing strategy that uses borrowed funds to buy options and futures to increase the impact of price movements.

However, leverage can work in the opposite direction as well and lead to losses for investors. If the underlying index falls by 1%, the loss is magnified by the leverage. Leverage is a double-edged sword meaning it can lead to significant gains, but it can also lead to significant losses. Investors should be aware of the risks to leveraged ETFs since the risk of losses is far higher than those from traditional investments.

The management fees and transaction costs associated with leveraged ETFs can diminish the fund’s return.

How Do Leveraged ETFs Work?

Leveraged ETFs work differently than traditional ETFs in that they attempt to amplify daily returns of a benchmark index, such as two-times or three-times, rather than just matching the performance of the index. To amplify the returns, leveraged ETFs use borrowed money to buy derivatives, such as futures contracts and option contracts.

For example, a traditional ETF that tracks the S&P 500 index seeks to match the returns of the index with a 1:1 ratio by buying and holding the stocks in the index. Leveraged ETFs may seek to achieve returns on a 2:1 or 3:1 ratio, expressed as 2x or 3x, respectively.

Investors interested in buying leveraged ETFs should note that they attempt to amplify the daily returns of a benchmark index, not long-term returns. For example, in 2018, the SPDR S&P 500 ETF (SPY), which is a traditional ETF, had an annual decline in price of -4.56%. But the 3x leveraged ETF, Direxion Daily S&P 500 Bull 3x ETF (SPXL), declined in price by -25.13% which is more than five times the decline as SPY, which tightly tracks the S&P 500 index.

Important: A leveraged ETF seeks to generate a daily return that is a multiple of a specified index’s return. Leveraged ETFs can also have inverse exposure, meaning the ETF will rise if the index falls.

Things to Consider

Some ETPs, such as geared ETPs, can be complicated. Before investing, be sure to ask:

  • How does the ETP achieve its stated objectives? And what are the risks? Ask about—and be sure you understand—what the products are designed to do and how they may behave in different market environments (for example, in a volatile market), as well as the techniques the ETP uses to achieve its goals and the risks they involve.
  • What happens if I hold a geared ETP longer than one trading day? While there may be trading and hedging strategies that justify holding leveraged and inverse ETPs longer than a day, investors with an intermediate or long-term time horizon should carefully consider whether these products are appropriate for their portfolio. You could suffer losses even if the longer-term performance of the underlying index is up for a leveraged ETP or down for an inverse ETP.
  • Is there a risk that a geared ETP will not meet its stated daily objective? There is always a risk that not every leveraged or inverse ETP will meet its stated objective on any given trading day. Be sure you understand the impact this could have on the performance of your portfolio, taking into consideration your goals and your risk tolerance.
  • What are the fees and expenses? Leveraged or inverse ETPs may be more costly than traditional ETPs. Use FINRA’s Fund Analyzer to estimate the impact of fees and expenses on your investment.
  • What are the tax consequences? Leveraged or inverse ETPs may be less tax-efficient than traditional ETFs, in part because daily resets can cause the ETP to realize significant short-term capital gains that may not be offset by a loss. There may be additional tax-related issues, so it is important to check with your tax advisor about the consequences of investing in these products.

The bottom line is that not all ETPs come with the same risks, and not every ETP is right for every investor.  Only invest if you are knowledgeable of and comfortable with the risks associated with these specialized products.

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