An Exchange-Traded Fund (ETF) is a financial instrument that tracks indices or a unique set of stocks in different sectors. ETFs are categorized based on various parameters, including the index they track, industry focus, commodity ETFs, currency ETFs, and so on.
Index-tracking ETFs such as SPF ETFs and NDX ETFs are further classified as leveraged ETFs, inverse ETFs, etc. Today, we will look at what Leveraged ETFs are, how they work, and the merits/demerits of investing in them.
What Are Leveraged ETFs?
A leveraged ETF is an index-tracking ETF that seeks to amplify the daily returns of the benchmark index. The ETF’s returns are magnified by using debt and derivative instruments such as options and contracts. Thus, a leveraged ETF will hold not only equity securities but also derivative instruments in the fund.
It is important to note that a leveraged ETF seeks to earn excess returns only on a daily basis and not for a longer time frame. Most of the derivative instruments used to leverage the ETF are short-term and come with a maturity date. Thus, investors must be mindful that the returns from a leveraged ETF may not be double or triple the returns of the underlying index over a longer term.
A leveraged ETF essentially rebalances every day, meaning it is marked to market each night and begins the next day with a clean slate. This also solidifies the notion that the returns generated by the ETF will not necessarily equate to double or triple times that of the underlying asset over a long period.
You will find leveraged ETFs for most indices including the Dow Jones Industrial Average (DJIA), the S&P 500 (SPX), and the Nasdaq 100 (NDX). By their very nature, leveraged ETFs are much riskier than traditional ETFs. Leveraged ETFs are often used as a tool to hedge against market downturns. Investors with a low-risk appetite should steer clear of leveraged ETFs.
What are the Different Types of Leveraged ETFs?
There are two main types of Leveraged ETFs, double-leveraged and triple-leveraged ETFs.
- Double-Leveraged ETFs aim to multiply the returns of the underlying asset by a factor of two, i.e., generate twice the returns (2x).
- Triple-Leveraged ETFs aim to multiply the returns of the underlying asset by a factor of three, i.e., generate thrice the returns (3x).
Examples of Leveraged ETF Calculations
Let’s look at an example of a 2x leveraged ETF to get clarity on its impact on your holding. Suppose we invest $100 in the ETF, and the underlying index moved up by 2% on Day 1:
Index return = $100 + ($100 x 2%) = $102
ETF return = $100 + ($100 x (2%*2)) = $104
Now, let us assume that on Day 2, the index falls by 2%. This will bring the index’s value down to $99.96 but the impact on the leveraged ETF will be double that and the value will fall to $99.82.
Index return = $102*(-2%) = $99.96
ETF return = $104*(-4%) = $99.82
Now that we have understood what a leveraged ETF is and how it works, let’s examine the advantages and disadvantages of leveraged ETFs.
Are Leveraged ETFs a Good Investment?
Advantages of Leveraged ETFs
- Exposure to Derivatives – An individual investor may not be comfortable trading in derivative contracts. A leveraged ETF gives exposure to derivative instruments of all types, including options and swaps.
- Liquidity – An ETF, per se, gives investors the advantage of easily trading them on exchanges, like companies’ stocks. In addition, leveraged ETFs have even greater daily trading volume since they are traded on a short-term basis, owing to their nature of being leveraged.
- Potential for Excess Returns – As mentioned, a leveraged ETF has the potential to generate returns above the underlying asset, mostly double or triple the times. An investor can benefit from excessive returns if he/she trades in leveraged ETFs with caution.
Disadvantages of Leveraged ETFs
- Excess Market Risk – Since leveraged ETFs seek to generate outsized market returns, they also pose an excess market risk for the investor. On a tumultuous trading day, an investor can lose most or all of the value of an ETF.
- Higher Fees – Since the fund managers of leveraged ETFs try to maximize returns on a daily basis, their expense ratios are generally higher than those of traditional ETFs. Expenses related to trading financial derivatives, management fees, and transaction fees can diminish the fund’s return.
- Risky Long-Term Holdings – Holding leveraged ETFs should not be considered a long-term investment strategy. These ETFs are highly sensitive to market trends and their returns over a longer period may not necessarily meet the expected investment objective.
List of Leveraged ETFs
Below are some of the leveraged ETFs that investors can study and compare before making an investment decision. Click on any ETF ticker to further research them on TipRanks’ unique platform.
- ProShares UltraPro QQQ (TQQQ)
- ProShares UltraPro Short QQQ (SQQQ)
- Direxion Daily Semiconductor Bull 3x Shares (SOXL)
- ProShares Ultra QQQ (QLD)
- ProShares Ultra S&P 500 (SSO)
- Direxion Daily S&P 500 Bull 3x Shares (SPXL)
Ending Thoughts
Investing in leveraged ETFs carries high risk coupled with high rewards. Investors should be well aware of both the pros and cons of investing in leveraged ETFs and invest in them according to one’s own risk-reward appetite. These ETFs can also be used as a hedge against market trends, but amateur investors might find it best to steer clear of them.
As always, investors can use the TipRanks ETF page to research and study their performances and make informed investment choices.
