Leveraged exchange-traded funds (ETFs) are tradable funds that allow investors to make magnified bets on an underlying index. Leveraged ETFs have been popular among investors looking to amplify their exposure to a market with a single trade. But they have their risks, like all investments.
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 sizable returns when held for an extended time. That means investors may not see the returns they expect.
How Do Leveraged ETFs Work?
Exchange-traded funds, or ETFs, are securities, but themselves are a form of index investing. They’re typically baskets of stocks, bonds or other assets that aim to mirror the moves of an index, though ETFs can have many different aims or goals. 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.
In finance, 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.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
What Is ‘Decay’ in Leveraged ETFs?
There are pros and cons to ETFs themselves. But leveraged ETFs can be particularly problematic for investors due to 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.
Pros of Leveraged ETFs
Easy Leveraged Trades
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.
Useful For Quick Leveraged Market Wagers
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.
Allow For Easy Shorting
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
Potential For Outsized Losses
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.
Rebalancing Needs
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.
Increased Investment Risk
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.
Derivative Risks
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.
Higher Costs
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%.
Closure Risks
There’s a high risk of closure. 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.
💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
Regulation of Leveraged ETFs
Regulators’ rules on leveraged ETFs have varied in recent years. And they continue to change. In early 2023, the Securities and Exchange Commission (SEC) issued a bulletin about leveraged ETFs, warning investors about the particular risks associated with them.
In October 2020, the SEC 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. 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. As always, it’s important to do your research about any ETF or investment before investing.
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