What Is a Leveraged ETF?
A leveraged ETF is an exchange-traded fund that uses financial derivatives and debt as leverage to amplify the returns of an underlying index, such as the S&P 500. The typical ETF attempts to match the returns of the index over time; however, a leveraged ETF attempts to double or triple the daily returns of the index.
Note: We emphasize 'daily' returns here because the derivatives used to achieve leverage in these ETFs are very short term and are not intended to provide the same leverage over longer periods. As a result, leveraged ETFs will track closely to their objective, whether 2x or 3x relative to the benchmark return, over a single day, but are not expected to track as closely to long-term moves over weeks, months, or years.
How Do Leveraged ETFs Work?
Leveraged ETFs work differently than traditional ETFs in that they attempt to amplify daily returns of a benchmark index, such as two-times or three-times, rather than just matching the performance of the index. To amplify the returns, leveraged ETFs use borrowed money to buy derivatives, such as futures contracts and option contracts.
For example, a traditional ETF that tracks the S&P 500 index seeks to match the returns of the index with a 1:1 ratio by buying and holding the stocks in the index. Leveraged ETFs may seek to achieve returns on a 2:1 or 3:1 ratio, expressed as 2x or 3x, respectively.
Investors interested in buying leveraged ETFs should note that they attempt to amplify the daily returns of a benchmark index, not long-term returns. For example, in 2018, the SPDR S&P 500 ETF (SPY), which is a traditional ETF, had an annual decline in price of -4.56%. But the 3x leveraged ETF, Direxion Daily S&P 500 Bull 3x ETF (SPXL), declined in price by -25.13% which is more than five times the decline as SPY, which tightly tracks the S&P 500 index.
Important: A leveraged ETF seeks to generate a daily return that is a multiple of a specified index's return. Leveraged ETFs can also have inverse exposure, meaning the ETF will rise if the index falls.
Do Leveraged ETFs Cost More?
When compared to traditional ETFs, leveraged ETFs generally have higher expenses. For example, the average expense ratio for a traditional ETF is 0.45%, whereas average expenses for leveraged ETFs are 0.95%. Because these expenses are taken from the fund, they reduce the net return to the investor.
Pros & Cons of Leveraged ETFs
There are potential benefits of investing in leveraged ETFs but there are some clear disadvantages that investors should know about before buying shares.
Pros of Leveraged ETFs
- Access to derivatives: Leveraged ETFs offer indirect access to financial derivatives, such as options and futures contracts, that may otherwise be inaccessible to everyday investors, or more expensive to trade.
- Easily tradeable: Like traditional ETFs, shares of leveraged ETFs trade in the open market like stocks.
- Potential for outsized returns: Leveraged ETFs amplify the daily returns of an underlying benchmark index, providing the potential for larger gains than traditional ETFs.
Cons of Leveraged ETFs
- Excessive market risk: The potential for outsized gains brings with it the potential for outsized declines in value. Unless the market is constantly moving in the same direction, which is not typical, leveraged ETFs will generally see value erosion over time.
- High fees: Leveraged ETFs cost more to manage than traditional ETFs because of the additional expenses associated with trading financial derivatives.
- Poor long-term holdings: Since leveraged ETFs are intended to amplify the daily returns of a benchmark index, they should only be used as short-term holdings. Leveraged ETFs see long-term returns that do not track the index, generally experience value erosion over time, and do not amplify returns in equal measure.
Warning: Leveraged ETFs are inherently more risky than traditional ETFs. While investors may receive amplified returns with leveraged ETFs, the declines in value are also amplified. Furthermore, due to the way they are constructed, these instruments usually experience value erosion over time. Because of these unique qualities, leveraged ETFs are best used by short-term traders and are not generally appropriate as long-term investment holdings.
What Are Double and Triple Leveraged ETFs?
Many leveraged ETFs are either double or triple leveraged, meaning that they amplify the returns of a benchmark index by two or three times, respectively.
- Double Leveraged ETF, or 2x leveraged ETF, seeks to double the daily returns of the index.
- Triple Leveraged ETF, or 3x leveraged ETF, seeks to triple the daily returns of the index.
Leveraged ETF Performance Example
For example, consider the example of a 3x leveraged ETF where the benchmark rises from 100 to 102 (+2%) on day-1, and falls from 102 back to 100 (-1.96%) on day-2. The benchmark index is back to its original level of 100, so has flat performance.
For the leveraged ETF, however, the return would be negative. To illustrate, after the first day of trading, an initial $100 investment on a 3x leveraged ETF would rise to $106.
$100 initial + (($100 x 2% index return) x 3) = $106
The next day the 3x leveraged ETF would drop 5.88% (3 x -1.96%), resulting in a value of only $99.77.
$106 - 5.88% = $99.77
Even though the benchmark index was flat, the leveraged ETF would have resulted in a loss of -0.23% over these 2 days.
$99.77 - $100 initial value = $-0.23
What Is an Inverse Leveraged ETF?
Inverse ETFs are designed to produce positive returns when a benchmark index declines. Inverse leveraged ETFs are thus designed to have a 2x or 3x move in the opposite, or "inverse", direction as the benchmark index. For example, if the benchmark index falls in price by -1% in a day, the 2x inverse leveraged ETF would theoretically produce a price increase of 2%.
Inverse leveraged ETFs have a similar effect as Short Selling, although would still suffer from value erosion over time due to their leveraged nature.
