A leveraged exchange-traded fund (ETF) is a type of financial product designed to track an underlying index at higher rates of return. It can offer returns as high as 2-3 times the returns of a traditional ETF, but that also makes it a riskier investment option.
Leveraged ETFs are quickly becoming one of the most popular types of ETFs. And while they are an aggressive new ETF innovation, they are also a controversial one. Before you can formulate an opinion on whether these new funds are good for you, 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. Generally, a leveraged ETF is designed 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% return on investment (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 returns of 2–3 times the opposite of the index.
How Leveraged ETFs Work
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. In other words, leveraged ETFs can be tied to different industry sectors, commodities, or currencies, just as regular ETFs can be.
Whether they are standard-leveraged or inverse-leveraged ETFs, both are designed to trade and generate returns on a daily basis rather than over a longer period of time.
Benefits of Leveraged ETFs
The most attractive feature of leveraged ETFs is their potential for high returns. With the ability to outperform the underlying index by two or three times on a daily basis, the rewards can be significant. Inverse leveraged ETFs offer investors a chance at major returns even if the market is falling since they can buy short.
Because there are so many types of ETF products available, there is a product for almost any investor interested in these benefits.
The Risks of Leveraged ETFs
However, as a derivative product with a high return potential, leveraged ETFs are a fairly high-risk investment.
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.
Because a leveraged ETF is designed to create multiple returns on a daily basis, it's not likely to generate returns that high. 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 can 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.
These aren’t the only issues with leveraged ETFs. There are tracking errors, borrowing complexities, and other constraints. These are not a product for the beginning investor.
Portfolio Management With Leveraged ETFs
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. You should only attempt to trade these securities with a lot of prior experience—and the help of a good broker.
To get an initial feel for this market, pay attention to how some leveraged ETFs react to market conditions and conduct thorough research. A few examples to follow include:
Additional Leveraged ETF Resources
- A leveraged exchange-traded fund (ETF) is a type of financial product that attempts to exceed the returns of its underlying index.
- Investors can also purchase inverse leveraged ETFs that are designed to perform at higher rates in the opposite direction of the index.
- Leveraged ETFs can return two or three times as much per day as a traditional ETF, but there are higher risks involved.