Leveraged exchange-traded funds (ETFs) are tradable funds that allow investors to make magnified bets on an underlying index.
ETFs are a type of index investing. They’re typically baskets of stocks, bonds or other assets that aim to mirror the moves of an index as closely as possible. Leveraged ETFs use derivatives so that investors can double (2x), triple (3x) or short (-1) the daily gains or losses of the index. Financial derivatives are contracts whose prices are reliant on an underlying asset.
Leveraged ETFs have been popular among investors looking to amplify their exposure to a market with a single trade. But it’s important for investors, particularly inexperienced ones, to understand the investment risks of leveraged ETFs.
Because of how they augment price swings, leveraged ETFs can cause massive losses. And for reasons related to their inner mechanics, they’re not good at delivering 2x or 3x returns when held for an extended time. That means investors may not see the returns they expect.
How Do Leveraged ETFs Work?
Leverage is the practice of using borrowed money to increase the potential return on an investment. Leveraged ETFs use derivatives to increase the potential return on an investment.
Let’s look at a hypothetical example. Say an investor buys a regular, non-leveraged ETF. Here’s how such an ETF would work. If it tracks the S&P 500 Index and the benchmark gauge rises 1% on a given day, the non-leveraged ETF would also climb about 1%.
If however the investor buys a triple leveraged ETF or 3x ETF, their return for that given trading day could be a 3% gain.
The reverse scenario could also happen though. If the S&P 500 fell 1% on a given day, the owner of the triple leveraged ETF can suffer a 3% loss.
What is ‘Decay’ in Leveraged ETFs?
There are pros and cons to traditional ETFs themselves. But leveraged ETFs can be problematic in their design. They are constructed to deliver multiples of an underlying asset’s daily returns, not weekly, monthly or annual returns. Leveraged ETFs don’t deliver the exact magnitude of 2x or 3x if held for longer than a day.
So if the S&P 500 were to rise 5% in a week, a triple leveraged S&P 500 would not climb 15% in that week. The same would be true for a double leveraged ETF. There’s no guarantee it would return 2x or 10% to its owner.
That’s because of how leveraged ETFs are constructed. In order to maintain their 2x or 3x exposure, leveraged ETFs use derivatives that need to be rebalanced at the end of each day. This process can erode the returns of the ETFs — a process known as “decay” in the market.
Types of Leveraged ETFs
1. Double Leveraged (2x) ETFs give investors double exposure to the daily return of an index of stocks, bonds or commodities. So if an asset or market moves 1.5% in a single day, the fund aims to deliver a return of 3% that day.
2. Triple Leveraged (3x) ETFs try to provide investors with 3x amplification. So if the underlying asset or index rises or falls 2% on a trading day, the ETF seeks to rise or fall 6%.
3. Inverse (-1) ETFs are also considered to be leveraged ETFs. They move in the opposite direction of the underlying asset they’re designed to follow. So if an index moves -1%, the ETF would aim to climb 1%, and vice versa. Inverse ETFs are essentially a form of shorting a stock. Investors are able to short the underlying market by buying shares of an inverse ETF.
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Pros of Leveraged ETFs
1. Leveraged ETFs have made it easier for investors to make leveraged wagers on the market, which can be a day-trading strategy but not a practice that’s readily available to all investors, particularly retail investors at home who may be trading in smaller increments. Leveraged and inverse ETFs had about $33 billion in assets in October 2020, according to business publications.
2. Leveraged ETFs can be useful for a one-day wager that an investor wants to make on an underlying market, such as technology stocks, high-yield bonds, or emerging markets.
3. Inverse ETFs can give investors the ability to short, or bet against, an asset. Short sales aren’t easily available to non-professional investors, particularly retail investors at home. Shorting can be a way for investors to hedge or offset the risk in their holdings.
Cons of Leveraged ETFs
1. With leveraged ETFs, investors could potentially see outsized losses due to how the products compound returns. For instance, if an index were to tumble 3% in a single day, a holder of leveraged ETFs would experience a plunge of 9% in the shares of their fund.
2. Because of how they’re constructed, leveraged ETFs need to be rebalanced daily. This process can cause what’s known as “decay” in the fund, when the performance veers from the underlying asset’s returns. This means investors may not see the 2x or 3x returns if the leveraged ETF is held for longer than a single trading session.
3. Inverse ETFs allow investors to short assets, but because of how there’s no limit to how high an asset can go, that means investors could see their holdings in the inverse ETF go to zero.
4. Leveraged ETFs use derivatives to achieve their amplified returns. Therefore, investors should be aware of the counterparty risk–or the risk from the other parties involved in the derivatives.
5. Leveraged ETFs tend to be more expensive than traditional ETFs. Investors who want to understand how fund fees work should look at the ETF’s expense ratio. For instance, some popular leveraged ETFs can have an expense ratio of 0.95%. That compares with more traditional ETFs, which can have an expense ratio of around 0.20%.
6. There’s a high risk of closure. Business publications noted that more than 30 leveraged ETFs closed after the market volatility experienced by investors in the Covid-19 pandemic. Investors who don’t sell out of their leveraged ETF shares before the delisting date could be left with positions that are difficult or costly to liquidate.
Regulation of Leveraged ETFs
Regulators’ rules on leveraged ETFs have varied in recent years. In October 2020, the Securities and Exchange Commission made a rule change that would make it easier to launch leveraged ETFs, while capping the amount of leverage at 200%.
The move was a break away from prior announcements that sought to slow down the creation of new leveraged ETFs. The SEC had previously allowed existing leveraged ETFs to be continued to be traded, while putting restrictions on the approval of new such funds. The SEC issued an alert about leveraged funds to retail investors in 2009.
In May 2017, the SEC approved the first quadruple (4x) leveraged ETF, only to halt its decision soon after.
Some investment firms and ETF providers have pushed for the term “ETF” to not be applied to leveraged and inverse funds. They argue that the term “ETF” is used for a range of products that can lead to significantly different outcomes for investors.
The Takeaway
Leveraged ETFs use derivatives in their construction to try to deliver amplified returns for an investor. Relative to index funds, ETFs can allow entire markets to be more easily traded, similar to how shares of a stock are traded.
Investors poured money into leveraged ETFs in 2020 amid the market volatility and rebound brought about by the Covid-19 pandemic. However, leveraged ETFs are not safe for all investors, particularly inexperienced ones.
These ETFs can cause massive losses because of how they magnify returns. In addition, market observers and regulators have said that leveraged ETFs may be better suited for professional or experienced investors to be used within a single trading session.
The use of derivatives in such funds causes their performance to veer from the underlying market if the ETFs are bought and held.
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