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What is a leveraged ETF?

Definition​

A leveraged ETF is a type of tradable asset that utilizes financial derivatives and borrowing to increase the gains of a fundamental index. Unlike a regular ETF that follows the securities in its underlying index at a 1:1 ratio, a leveraged ETF seeks to achieve a 2:1 or 3:1 ratio.

Various indexes, including the Nasdaq 100 Index and the Dow Jones Industrial Average (DJIA), have leveraged ETF options.

Gist​

  • A leveraged ETF employs financial derivatives and borrowing to increase the returns of a base index.
  • Unlike a regular ETF that mirrors the securities in the underlying index, a leveraged ETF strives for a 2:1 or 3:1 ratio.
  • Leverage has its advantages and disadvantages, as it can result in considerable profits or losses.

Leveraged ETFs Explained​

ETFs are investment funds that hold a collection of securities from an index they are tracking, such as the S&P 500. This means that if the index moves up or down by a certain percentage, the ETF will follow suit. A leveraged ETF that tracks the S&P may use financial tools and borrowed funds to amplify the gains, meaning a 1% increase in the index could result in a 2% or 3% gain for the ETF. However, this leverage also means that losses can be magnified, making it a high-risk strategy. Investors should be aware of the potential downsides, including management fees and transaction costs that can eat into returns.

The Leverage in Leveraged ETFs​

A leveraged ETF can increase exposure to a specific index by using derivatives like options contracts, but it only tracks daily changes rather than amplifying annual returns. Options contracts enable investors to trade an underlying asset without the obligation to buy or sell the security, but they have an expiration date and upfront fees. Leveraged ETFs use options to enhance the gains of traditional ETFs, and portfolio managers can borrow to buy additional shares of securities for added potential gains. A leveraged inverse ETF uses leverage to make money when the underlying index is declining, allowing investors to profit from a bearish market or market declines.

The Costs of Leverage​

In addition to management and transaction fees, leveraged exchange-traded funds may have additional expenses, such as premiums for purchasing options contracts and borrowing costs. The fees for leveraged ETFs are typically higher than those for non-leveraged ETFs, with expense ratios often exceeding 1%. However, despite these costs, leveraged ETFs may still be a more cost-effective option than other forms of margin trading. Margin trading involves a broker lending money to a customer to purchase securities, with the securities held as collateral for the loan and an interest rate charged. Short selling and buying stock on margin can be even more expensive, with fees of 3% or more and the risk of margin calls if the securities lose value.

Leveraged ETFs as Short-term Investments​

Traders often use leveraged ETFs to speculate on or take advantage of short-term momentum in an index. However, due to the high risk and cost associated with these ETFs, they are not typically used as long-term investments. This is because the derivatives used to create leverage are not suitable for long-term investments, making it difficult to hold positions for extended periods. Instead, traders tend to hold positions for just a few days or less, as holding for longer periods can result in returns that differ significantly from the underlying index. While leveraged ETFs offer the potential for significant gains and a wide variety of securities to trade, they also come with the risk of significant losses, higher fees and expense ratios, and are not suitable for long-term investment strategies.

Real World Example of a Leveraged ETF​

The FAS ETF, which follows the Russell 1000 Financial Services index, holds stocks of major American financial companies. Its expense ratio is 0.99% and its top holdings are BRK.B, V, and JPM. The ETF aims to provide investors with three times the return of the financial stocks it tracks. If an investor puts $10,000 in the ETF and the index rises by 1%, the ETF will return 3%. However, if the index falls by 2%, the FAS will lose 6%. Leveraged ETFs are typically used for short-term market movements and can result in significant gains or losses for investors in a short period of time.

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