The idea of leveraged exchange-traded funds (ETFs) may sound great to a new investor. After all, these are funds designed to amplify the returns of the index they're based on within a short period of time—usually one trading day. But some investors attracted by upside forget the risks that go along with using that leverage.
Since leveraged ETFs are specially created financial products designed for speculators, individuals who buy or trade them without understanding how they work should be extra cautious.
This is because many leveraged ETFs are not structured like ordinary ETFs. Keep reading to learn why.
The Difference Between Leveraged and Regular ETFs
An ordinary ETF is a pooled mutual fund that owns an underlying basket of securities or other assets, most often common stocks. That basket trades under its own ticker symbol throughout the ordinary trading day, the same way shares of a company like Facebook or Amazon do.
From time to time, the net asset value (the value of the underlying securities) may deviate from the market price, but, on the whole, the performance should track the underlying index and equal that performance over long periods (minus the expense ratio). Simple enough.
With a leveraged ETF, however, the fund uses debt and derivatives to amplify the returns of the underlying index at a ratio of 2-to-1 or even 3-to-1, instead of 1-to-1 like a regular ETF. The financial derivatives and debt used in these funds introduce an outsized amount of risk, even as they have the potential to produce outsized gains. Leveraged ETFs also often come with higher expense ratios than regular ETFs.
Where a regular ETF tracking an index could fall 5%, a leveraged ETF would fall 10% or 15%. Leveraged ETFs may see drastic drawdowns.
What Happens When You Buy and Hold an ETF Like TQQQ
With a leveraged ETF, on top of the asset management fees, frictional expenses such as trading costs, and custody fees, you have the interest expense of the debt used to achieve the actual leverage. That means that every moment of every day, interest expense or its effective equivalent is reducing the value of the portfolio.
Let's take a look at one such ETF, the ProShares UltraPro QQQ (Nasdaq: TQQQ), which leverages the Nasdaq-100 3-to-1. If the Nasdaq-100 moves by 1%, TQQQ moves by 3%.
If the market goes sideways, the ETF's shares are destined to lose money, a reality that is exacerbated by the fact that the portfolio rebalances daily. Due to compounding, leveraged ETFs held over the long term can see strikingly different returns than the fund's target. Because these funds reset each day, you can see significant losses—even if the fund itself appears to be showing a gain.
In other words, even if the market ends up increasing in value over a multi-month period of time, and even if you are leveraged 3-to-1 on that increase, it is possible that the gains of your leveraged fund will not triple the gains of the underlying index. In fact, the ETF could actually end up losing money because of the combination of daily rebalancing and how it harms you during periods of high volatility. Additional expenses, interest, and transaction costs will also intensify this effect
Who Should Consider Leveraged ETFs?
Who are these leveraged ETFs designed for, then? What types of people or institutions should consider buying or selling them? The answer is clear when you understand that they aren't meant for long-term investment at all.
Investing involves owning shares of companies and collecting dividends, or lending money and collecting interest income, and it is necessary for the functioning of the economy. Investors often follow long-term strategies and have future goals in mind when buying stocks, ETFs, or other investments.
The purpose of leveraging a stock market benchmark (such as the Nasdaq-100) by 300% and then resetting it every day is a way to gamble without risking the dangers of directly employing margin debt. You can take the long side (bet that it will increase) or the short side (bet that it will decrease) as both have their own respective ticker symbols.
Leveraged ETFs are really meant for those with deep pockets who can afford to take the outsized risk and are willing to bet that stocks will go up or down on any given day.
Understanding the Risks for New Investors
The takeaway of all of this for new investors is simple: Don't invest in something you don't understand. If financial derivatives, options contracts, and futures—all of which are tools used in leveraged ETFs—are beyond your comfort zone, stick to other investments.