The majority are double-leveraged, but there's a sizeable group of triple-leveraged ETFs. For professional investors, leveraged ETFs are useful in statistical arbitrage, short-term tactical strategies, and for use as short-term hedges without the need to roll futures.
For individual investors, leveraged ETFs are alluring because of the potential for higher returns. That is absolutely not the case.
The leverage is determined on a daily basis and the returns for any other period usually will not be double or triple the underlying index. In order for the leveraged funds to achieve appropriate levels of assets so they can provide their implied leverage, they have to rebalance daily. In the case of an ETF providing long 2-times leveraged exposure, they would typically attain exposure to a notional set of assets equal to 2 times their NAV.
An example would be an ETF that takes in units in assets that does a swap with a counterparty to provide exposure to units in performing assets. The rebalancing activity of these funds will almost always be in the same direction as the market. In essence, a leveraged ETF is essentially marked to market every night. It starts with a clean slate the next day, almost as if the previous day had not existed. This process produces daily leverage results. However, over time, the compounding of this reset can potentially vary the performance of the fund versus its underlying benchmark.
This can result in either greater or lesser degrees of final leverage over individual holding periods. Generally speaking, daily compounding of leveraged long ETFs can result in increasing percentage gains in rising markets and decreasing percentage drops as markets trend lower.
If an index rises for several days in a row, the trending movement is very important, as that will translate into ETF growth at a faster pace as the value of the index is increasing. For a long leveraged product, it will outperform its expected goals in a rising market and will underperform its expected goals in a falling market. The index and the double-leveraged ETF tracking that index both started out at In essence, the ETF is doing what it is supposed to do: produce results that equal 2 times the daily performance of the index.
However, because of an increasing price, those gains are driving the value higher at a faster pace. What this shows is that in a trending market—because of daily compounding—you achieved a return of much greater than twice the index return. In the next chart, you can see the grid depicting the opposite event. The daily compounding of the leveraged ETFs will magnify this effect. For investors already familiar with leveraged investing and have access to the underlying derivatives e. These investors will probably be more comfortable managing their own portfolios, and controlling their index exposure and leverage ratio directly.
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We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. About Leveraged ETFs. Maintaining Asset Value. Index Exposure. Daily Rebalancing. Performance and Fees. Interest and Transaction. The Bottom Line. Key Takeaways Leveraged ETFs are designed to offer greater returns than normal exchange-traded funds.
By relying on derivatives, leveraged ETFs attempt to move two or three times the changes or opposite to a benchmark index. A disadvantage of leveraged ETFs is that the portfolio is continually rebalanced, which comes with added costs.
Experienced investors who are comfortable managing their portfolios are better served by controlling their index exposure and leverage ratio directly, rather than through leveraged ETFs.
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Related Articles. Partner Links. These simplified examples show you how easy it is to lose money using leverage because stock prices move up and down every day.
The price fluctuations over time are why a leveraged ETF should not be held, along with the fact that they reset every day. A leveraged ETF also resets itself every trading day to the underlying index.
This means that if you were to try to buy and hold, you would have your position reduced to zero under most ordinary volatility conditions. Over time, the mechanics of the ETF itself would strip away all of your funds, even if the market ended up going straight to the moon. This is a nuance lost on many new investors who try to invest in a fund meant for very short-term speculation. Though the temptation to speculate with leveraged ETFs may be strong, it should be clear that they are not intended to be part of a diversified, long-term portfolio.
If you have an advisor and they place one of these into your account, you should consider finding another advisor. If you've included one in an individually managed account or bought them for your brokerage account , you are taking an extreme risk with your money. You can and probably will lose a substantial amount of money if you keep a leveraged ETF. This is because they are designed to be traded over short time frames, like one trading day. There are leveraged ETFs designed for longer terms, such as a month, but this doesn't reduce the risk you take.
Furthermore, the payoff may not be as high as you envision. If you're successful trading leveraged ETFs, your gains will all be taxed at the much higher income tax rate since they are short-term gains.
If you're looking to build wealth , it is simple enough. You buy high-quality blue-chip stocks. Make sure you find stocks that let you take advantage of deferred tax liabilities through low turnover and let compounding do the rest.
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