Takeaways

• Apart from equities, leveraged ETFs hold derivatives and debts to achieve double or triple the daily returns of an index.
• They’re usually used as short-term holding.
• They amplify returns as well as risks compared with non-leveraged ETFs.

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What is a leveraged ETF?

Non-leveraged ETFs usually hold the common stocks in an index to match its performance. In contrast, leveraged ETFs hold equities, as well as derivatives and debts—for example, options contracts—to achieve 2 or 3 times the daily returns of an index.

This means every dollar you invested would generate a return equal to 2 or 3 times the daily returns of an index.

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How does leverage work?

When we invest in non-leveraged ETFs, we expect them to follow the movements of the index. When the index moves by 1% in a day, the ETF moves by 1%. When the index moves by 2% over a week, the ETF moves by 2%.

This is not the case with leveraged ETFs.

Leveraged ETFs use short-term debt or derivatives to double or triple the daily returns of an index, not the returns over the long term. Your daily returns will be compounded, and the fund will rebalance its portfolio daily to achieve 2x or 3x leverage on a new day.

That’s to say, if an index increases by 1% in a day, you can expect an ETF seeking 3x of its returns to go up by about 3%. However, if an index increases by 2% over a week, the index will not necessarily climb up by 6%.

Similarly, if the index drops by 1% in a day, an ETF seeking 3x of its returns would go down by about 3%. However, if an index declines by 2% over a week, the ETF may drop by more or less than 6%.

Let’s look at some examples.

Both ABC and XYZ track the Nasdaq 100 index (NDX). ABC seeks a positive 1x of the index while XYZ seeks a positive 3x.

As we can see below, over the 6-month range, the performance of ABC and NDX has overlapped, both showing a decline of about 7%.

On the other hand, XYZ has shown a daily return of about 3x of the change of NDX. However, over the 6 months, XYZ has declined by about 35%, almost 5 times the decline of NDX.

Zooming in, we can see that over the 10-day range, the index increased by 5%. Correspondingly, ABC rose by about 6%. XYZ, however, increased by nearly 20%, a four times leverage.

What are the pros and cons of leveraged ETFs?

Amplified profits are usually the first reason that many investors invest in leveraged ETFs. Pros of leveraged ETFs can be:

• Potential amplified returns. Leveraged ETFs provide 2 or 3 times the daily returns of an index.
• Access to derivatives. Some derivatives might be too complicated and risky for regular investors to try. Leveraged ETFs give investors access to derivatives with limited risks.

As enticing as the returns can be, leverage ETFs have a few disadvantages.

• Amplified risks. Leverage amplifies returns as well as losses. If the benchmark diverges from your expectations, you’ll suffer bigger losses compared to investing in non-leveraged ETFs. Although the risk is limited, you can still lose your entire investment.
• Higher expense ratio. Leveraged ETFs have higher expense ratios than non-leveraged ones.
• Not suitable for long-term holding. Leveraged ETFs aim to leverage the daily returns of an index. They do not offer the same leverage over the long term.

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