In this article, you will learn:
- What a leveraged ETF is and how it works
- The types of leveraged ETFs
- Benefits & risks of leveraged ETFs
- Bottom Line: Should you invest in leveraged ETFs?
This article provides important details regarding leveraged ETFs that investors can use to optimize their decisions.
What is a Leveraged Exchange-Traded Fund (ETF) & How Does It Work?
A leveraged ETF uses financial derivatives and/or debt in an attempt to enhance the investment returns that otherwise would be produced by an underlying stock market index. Whereas a traditional ETF aims to proportionately replicate the returns of securities in an overall stock market index that it’s tracking, leveraged ETFs seek to improve those returns to beat the index returns.
Like conventional ETFs, leveraged ETFs are available for most of the popular stock market indexes. However, there is one key difference. When examining a regular ETF that’s tracking the Nasdaq 100 Index, for example, the ETF will move 2% if the index moves 2%. Leveraged ETFs, on the contrary, may move twice or three times that of the underlying index. This is essentially achieved by using leverage, or debt, to purchase options, futures and other derivatives to augment the effect of price changes. Thus, by utilizing debt and financial derivatives, an investor can take advantage of leveraged ETFs to generate a return that is greater than the index that it’s tracking.
For example, let’s look at the largest and most heavily traded leveraged ETF. TQQQ tracks the Nasdaq-100 and aims to achieve 3x the daily return of the index. Suppose it’s currently trading at $135 and has a single-day return of 1%, which is equivalent to $136.50. However, the leveraged ETF would deliver a 3% return, leading to a position at $139.05.
The Types of Leveraged ETFs
There are essentially only two categories that all leveraged ETFs fall under: 2x and 3x. As previously mentioned, leveraged ETFs track indexes like regular ETFs, except they’re designed to exceed the single-day change of that index. In the case of a 2x leveraged ETF, it’s meant to double the change of a given index, whereas a 3x leveraged ETF is meant to triple the change. The expected return of a leveraged ETF is proportional to the amount of debt/leveraged being utilized, so a 3x leveraged ETF uses more borrowings and derivatives than a 2x type.
Below is a short list of 2x and 3x leveraged ETFs that you can explore:
- TQQQ – ProShares UltraPro QQQ (3x)
- QLD – ProShares UltraPro QQQ (2x)
- SSO – ProShares Ultra S&P 500 (2x)
- SOXL – Direxion Daily Semiconductor Bull 3x Shares (3x)
- FAS – Direxion Daily Financial Bull 3x Shares (3x)
- SPXL – Direxion Daily S&P 500 Bull 3x Shares (3x)
- TECL – Direxion Daily Technology Bull 3x Shares (3x)
- UPRO – ProShares Ultra S&P 500 (3x)
Benefits & Risks of Leveraged ETFs
Leveraged ETFs definitely have the potential to help investors increase their single-day returns. If an investor anticipates the investment to do well, the leverage used by the investor will help multiply their gains. However, the risks of investing in leveraged ETFs may outweigh the potential benefits.
Trading leveraged ETFs involves management fees and transaction costs that can accumulate in the long-run. Furthermore, losses can also be increased by the same magnitude as the potential gains. This is because any investment that uses leverage involves a lot more risk. The use of derivatives further escalates the risk. To that point, 3x ETFs are especially risky because in a volatile market, compounding can cause losses that are substantial.
For example, suppose you buy a leveraged ETF for $100 and the trading day ends with the underlying index up 10%. If this is a 2x leveraged ETF, it would equate to a $20 profit at an equity value of $120. Suppose that during the next trading day, the index falls 9.1% back to $100. The 2x loss would be an 18.2% loss on the $120 which amounts to $21.84. This results in an equity value of $98.16. Thus, you incurred a loss on what should’ve resulted in a neutral position.
Bottom Line: Should You Invest in Leveraged ETFs?
Leveraged ETFs are funds that are structured to use debt and various financial derivatives to multiply returns. Though this can significantly benefit an investor, these ETFs involve compounding and leverage, which cause risks of losses being magnified as well.
Since leveraged ETFs are usually used by day-traders to boost single-day returns, these funds are generally invested in by experienced investors. Therefore, I would argue that less experienced investors should avoid leveraged ETFs.
Overall, leveraged ETFs aren’t preferred in the long-term because they seek to magnify only the daily returns. This means that the potential gain is limited to each single trading day. The volatility of the index, if the fund is held in the long-term, can also potentially result in greater losses than gains. Thus, leveraged ETFs are not recommended for investors who want to buy-and-hold for the long-term.