What Are They?
- Like many traditional index ETFs, leveraged market cap ETFs offer a simple way to get exposure to broad US market indexes, in this case defined by market cap (small cap, midcap or large cap stocks).
- But unlike traditional index ETFs, these ETFs provide double or triple the performance of a traditional index. So if the S&P 500 rises by 1%, for example, the ProShares Ultra S&P500 ETF (NYSEARCA:SSO) would rise by 2% and the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO) would rise 3%.
- Leveraged ETFs are able to do this by using by options and futures contracts. Because futures provide leverage (more exposure than the actual cash invested), ETFs that use futures contracts have uninvested cash, which they usually park in interest-bearing bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders.
Why and How To Use Them
- Active traders can use leveraged ETFs to play short-run market movements. Since they have more volatility than a regular index fund, the potential for gain (and loss!) is larger.
- Longer-term investors can use leveraged ETFs to increase their exposure to an index without needing to borrow money on margin. For example, they can be purchased in retirement accounts which don't allow margin lending.
What to Look Out For
- Leveraged Market Cap ETFs are riskier and more volatile than standard index ETFs, and can lead to greater losses.
- Leveraged ETFs are only meant to track a given index for a single day. Since these funds need to 'rebalance' daily to offer the proposed level of leverage during the following trading day, returns end up compounding over holding periods longer than a single day. These funds will not reliably track an index on a leveraged basis when held for more than one day; the longer the holding period, the more significant the tracking error is likely to be.
- There may be tax disadvantages from using leveraged ETFs versus buying traditional index ETFs (including on margin). An investor owning a futures-based ETF is taxed on any capital gains on the underlying futures held by the fund using the taxation convention for futures, ie. at a hybrid rate of 60% long-term, 40% short-term each year on all gains, even if the investor doesn't sell the fund. In contrast, long term gains on traditional index ETFs are taxed as long term capital gains, and if the index ETFs are purchased on margin, the interest payable on the margin loan counts as negative interest income. (Check this carefully with your accountant.)
- Leveraged ETFs tend to have higher expense ratios than standard index ETFs, even proportionate to the level of exposure. Also, the use of futures means that dividend income from stocks would be lower or non-existent; but the ETFs should produce some income from the cash invested in bonds.
- Leveraged ETFs may perform poorly in flat markets, and can underperform their benchmarks in conditions of significant volatility. See Further Reading below.
- Tristan Yates and Lye Kok discuss the risk that leveraged ETFs will produce sub-par long term performance in Leveraged ETFs: A Value Destruction Trap? and The Case Against Leveraged ETFs. Christopher Baldwin also comes out against leveraged ETFs in Clear Proof Against Leveraged ETFs.
- However, Brett Steenbarger shows in Are ProShares Ultra ETFs Used As Hedging Devices By Money Managers? that trading volumes for leveraged ETFs have grown strongly.
- Uses of leveraged ETFs are discussed in Leveraged ETFs For Upside Juice and Downside Protection and in Brad Zigler's Leverage and Inversion: A New Look for ETFs.
- Ron Rowland picks apart some of the more complex leveraged ETNs in Barclays Launches No-Reset Leveraged ETNs (with Confusing Names).
- See also other leveraged ETFs, including Leveraged Sector ETFs and Leveraged Growth/Value ETFs.
This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.