What are Leveraged ETFs?

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Exchange-Traded Funds, commonly known as ETFs, hold an underlying basket of securities that investors can purchase and sell without having to own each of the underlying assets.

Many ETFs are designed to serve as lower risk, long-term, passive investments. However, there are a few special types of ETFs that do not fit this mold. One of these exceptions is the Leveraged ETF, an investment vehicle with higher inherent investment risk due to the price volatility caused by the leverage utilized by the ETF. Leveraged ETFs are securities designed to be monitored daily and held for a limited period of time.

What is a leveraged ETF?

Chapter 2 – Understanding Leveraged and Inverse ETF from Direxion on Vimeo.

A Leveraged ETF multiplies the performance of an index by holding double or triple the exposure to the securities in the index it is tracking. This means that for every dollar you invest, you will receive a multiple return or loss (before fees and expenses) based on the leverage multiple of the ETF.

For example, lets say you invest $100 in an S&P 500 3x Bull Leveraged ETF. If the S&P is up 1% at the end of the day, youll now have ~$103. If the S&P is down 1% at the end of the day, youll now have ~$97. Investments held for a period longer than one day will be affected by compounding and may have an effective investment multiple which is more or less than the daily multiple of the ETF. More about compounding below.

Why is it potentially risky to hold a leveraged ETF for more than a day?

Chapter 3 – Daily Rebalancing from Direxion on Vimeo.

Leveraged ETFs allow sophisticated investors to bet on extremely short-term shifts in the market. Most ETFs buy and sell securities in their basket to reflect the index they track, generally quarterly (please read the ETFs prospectus as this can vary by ETF), a practice called rebalancing.

However, leveraged ETFs also have a daily rebalance function. The daily rebalance is designed to reset the exposure of the ETF to align with the ETFs investment mandate. For example, if you purchased a 3X Bull ETF, and at the end of the trading day the ETF had increased in value, then the portfolio manager must purchase additional exposure to rebalance the leveraged multiple of the ETF prior to the next trading day.

Because of the multiplier on the return and the daily rebalancing, holding leveraged ETFs for any longer than a day exposes your portfolio to investment leverage which may be more or less than the daily leverage of the ETF which could lead to higher daily investment gains or losses. This is called compounding risk.

Lets compare what would happen if you invested $100 in an S&P 500 ETF and a 3x Leveraged S&P 500 ETF in different market conditions.

Rising Market

DayS&P 500 PriceS&P 500 ReturnS&P 500 3x ReturnS&P ETF Investment3x Leveraged S&P ETF Investment
05,000.00$100.00$100.00
15,050.001.00%3.00%$101.00$103.00
25,151.002.00%6.00%$103.02$109.18
35,202.511.00%3.00%$104.05$112.46
45,358.593.00%9.00%$107.17$122.58
55,492.552.50%7.50%$109.85$131.77
Total Return492.559.85%31.77%$9.85$31.77

Over the course of 5 days, the leveraged investment gained more than 3x the return of the non-leveraged investment.

Falling Market:

DayS&P 500 PriceS&P 500 ReturnS&P 500 3x ReturnS&P ETF Investment3x Leveraged S&P ETF Investment
05,000.00$100.00$100.00
14,950.00-1.00%-3.00%$99.00$97.00
24,851.00-2.00%-6.00%$97.02$91.18
34,802.49-1.00%-3.00%$96.05$88.44
44,658.42-3.00%-9.00%$93.17$80.48
54,541.95-2.50%-7.50%$90.84$74.45
Total Return-458.05-9.16%-25.55%-$9.16-$25.55

Over the course of 5 days, the leveraged investment lost $25.55 – about 2.8x the loss of the non-leveraged investment.

Volatile Market:

DayS&P 500 PriceS&P 500 ReturnS&P 500 3x ReturnS&P ETF Investment3x Leveraged S&P ETF Investment
05,000.00$100.00$100.00
15,500.0010.00%30.00%$110.00$130.00
25,000.00-9.09%-27.27%$100.00$94.55
34,500.00-10.00%-30.00%$90.00$66.18
44,750.005.56%16.67%$95.00$77.21
55,000.005.26%15.79%$100.00$89.40
Total Return0.000.00%-10.60%$0.00-$10.60

Over the course of 5 days, the leveraged investment lost $10.60 while the non-leveraged investment remained flat.

How do investors determine the role of leveraged ETFs in their strategies?

Leveraged ETFs come with the potential for outsized gainsor lossesand require a more hands-on, short-term approach that may diverge from a typical long-term investing strategy. Sophisticated investors will sometimes combine long- and short-term approaches; however, its important to understand the full context before trading leveraged products.

Ask yourself the following questions:

  • Are you a sophisticated, experienced investor?
  • Do you understand how leveraged ETFs work, and how compound risk could impact performance?
  • Do you understand and accept the potential to lose substantial amounts in short periods of time?
  • Are you able to actively monitor and manage your leveraged ETF investments throughout the day by buying and selling shares?

If you can answer yes to all of the questions above, trading leveraged ETFs may be suitable for you.

The above content provided and paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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