If you’re up on your investment vehicles, you probably know what an ETF is. It’s short for exchange-traded fund and it’s a security that can be bought and sold. ETFs trade like regular stocks but they track other assets, like bonds, stock market indexes or commodities. A leveraged ETF is a particular kind of ETF that uses debt or derivatives to boost the potential for returns – and losses. Here’s what you should know about the leveraged ETF.
Check out our investment calculator.
How Leveraged ETFs Work
Let’s say you want to buy shares in an ETF that tracks a particular index like the S&P 500. If you buy shares in a regular ETF, the ETF will track that index but its shares will trade on the market. If the value of the underlying index goes up by 1% on a given day, the value of the ETF does too.
Let’s say that rate of return isn’t high enough for you. In that case, you may be tempted to buy a leveraged ETF. A leveraged ETF lets investors use debt to buy more ETF shares, or uses derivatives to magnify the investments of buyers in a particular index. So, if you had a 3x (also written as 3:1) leveraged ETF and the value of the underlying index increased by 1% in a given day, your returns would be 3%. But it works both ways. If the index loses 1% you’ll lose 3%.
And that’s where compounding comes in. A 2:1 leveraged ETF is only promising to maintain that 2:1 ratio over a short period, usually a single day. After that, it can’t keep it up because of compound interest. Here’s an example.
Say you invest $1,000 in a regular ETF that tracks a certain index. The index gains 5% on day 1, leaving you with $1,050. On Day 2, the index loses 6%. Now you have $987. On day 3, the index loses 7%. Now you have $917.91. On Day 4, the index gains 3%, bringing you to $945.45.
Now say you had invested that same $1,000 in a 2:1 leveraged ETF. On day 1 the index gains 5% and you have $1,100. On Day 2, the index loses 6% leaving you with $968. On Day 3 the index loses 7% and you have $832.48. At that point, you’re worse off than you would be with a regular ETF. On Day 4 the index gains 3%, which puts you at $882.43. You’re still behind, and you’ve left that 2:1 ratio behind.
Leveraged ETFs are by nature volatile. When you buy a leveraged security you’re taking the natural volatility of the stock market and multiplying it by the ratio of your leverage. Because leveraged ETFs compound daily, it can be hard to come back from big losses.
Check out our asset allocation calculator.
Leveraged ETF Fees
As always when you’re considering asset allocation, it’s a good idea to try to minimize the fees you pay for the management of your investments. Leveraged ETFs come with higher fees than non-leveraged ETFs, so you won’t actually see the full 2x or 3x return from your leveraged ETFs once fees are accounted for.
The twin effects of compounding and leverage mean that the value of a leveraged ETF can stray from the value of its underlying index over time. So, after 10 days if the S&P 500 is up, you may think, “That’s great!” But if over the course of those 10 days the S&P 500 gained and lost value, the leveraged ETF might actually be down after 10 days if it made big losses and, because of compounding and leverage, couldn’t recoup them.
That’s why traders will sometimes own a leveraged ETF for just one day. Of course, any security that you’re trading frequently will incur trading fees (unless you have enough invested that your brokerage has waived fees). All in all, that can make leveraged ETFs a risky and expensive proposition for the average Joe or Jane.
What is an inverse ETF? An inverse ETF takes a short position on the underlying asset. Need a refresher on what it means to “go long” or “go short” on an asset? If you take a long position, you’re betting that the asset will increase in value. A normal, non-inverse ETF or leveraged ETF is an example of a long position, because the buyer benefits when the asset’s value increases.
If you take a short position, you’re betting that the value of the underlying asset will decrease. An inverse ETF lets you short the underlying asset of an ETF. So, if the S&P 500 loses value and you have an inverse ETF that tracks the S&P 500, you win. But if the S&P 500 gains value, you lose.
Leveraged ETFs come in regular and inverse form. In other words, you can use a leveraged ETF to take a long or a short position. Want to short a particular commodity (like oil or gold) or a particular index? Look for an inverse ETF.
Related Article: What Are Exchange-Traded Funds?
Because of their high fees, leveraged ETFs don’t tend to be the kind of buy-and-hold investments that long-term investors make. Leveraged ETFs are more the province of short-term traders who want to take a more active role in their investments.
To be clear, it’s not necessary to take an active role when you’re investing. A low-fee index fund that tracks the market can do just fine if you’re investing your retirement savings. But if you have extra money to burn and you’re interested in trading as a hobby, the leveraged ETF might be of interest to you.
Photo credit: ©iStock.com/SIphotography, ©iStock.com/pichet_w, ©iStock.com/G0d4ather