What Are Leveraged ETFs?
Controversial & Innovative Funds
Leveraged Exchange Traded Funds are fast-becoming one of the most popular types of ETFs. And while they are an aggressive new ETF innovation, they are also a very controversial ETF innovation. However before you can formulate an opinion on whether these new funds are good or evil, you need to know the basics.
What Is a Leveraged ETF?
As usual, an ETF tracks an underlying index or investment product in order to emulate performance. The goal is not to outperform the correlating investment, but to give investors a beneficial way to mimic price.
Leveraged ETFs go a bit further. They do want to outperform the index or commodity they track. A leveraged ETF wants to provide 2-3 times the return of the correlating asset. So if the tracked index rises 1%, a 2x leveraged ETF wants to create a 2% ROI.
There are also inverse leveraged ETFs, which offer multiple positive returns if an index declines in value. They work the same as normal inverse ETFs, they are just designed for multiple returns.
What Is in a Leveraged ETF?
Leveraged ETFs are designed to include the securities in the underlying index, but also include derivatives of the securities and the index itself. These derivatives include, but are not limited to, options, forward contracts, swaps, and futures.
Again, a leveraged ETF is constructed with assets and derivatives in such a way that the return on the fund should be a multiple of the return on the index. As of right now, the most popular leveraged ETFs target 2x and 3x the return, but that could change once the controversy settles.
What Is the Controversy Surrounding Leveraged ETFs?
The answer to this question could be an article in itself and since leveraged ETFs are fairly new and still evolving, the answer to this question will constantly change.
Using a 2x leveraged ETF as an example, the simple concept is that if the index rises 1%, the leveraged ETF should create a 2% return. However, simple as that sounds, it’s not always the case.
The most common misconception is that leveraged returns are on a yearly basis. Not true. A leveraged ETF is designed to create multiple returns on a daily basis. So if an index has a yearly return of 2%, the leveraged ETF will probably not have a return of 4%. It will be more subject to the direction of the daily returns throughout the year.
Another risk of leveraged ETFs is that they create multiple negative returns. People hear “multiple returns” and think multiple profits, but a sound investor knows that reward comes at the expense of risk, and leveraged ETFs have high-risk rates due to their design.
And these aren’t the only issues with leveraged ETFs. There are tracking errors, borrowing complexities, and other constraints.
Should I Include Leveraged ETFs in My Portfolio?
There is no straight answer to this question. Every ETF investment strategy should be evaluated on a case by case basis. Using leveraged ETFs is an advanced investment strategy and should not be taken lightly. While ETFs offer many benefits, and leveraged ETFs could possibly increase returns, there are risks involved with leveraged ETFs. Risks that go beyond the risks of basic ETFs.
I suggest watching how some leveraged ETFs react to market conditions and conduct thorough research. Here are few to watch before you get started.
- QLD – Ultra QQQ ProShares ETF
- DDM – Ultra Dow 30 ProShares ETF
- SSO – Ultra S&P 500 ProShares ETF
To see more, feel free to check out my thorough list of leveraged ETFs. And I also have the lists broken down into double and triple funds, too...