What Are Leveraged Exchange-Traded Funds?

Broker watching stock and holding phone
•••

Yellow Dog Productions / Getty Images

DEFINITION
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 two or three times the returns of a traditional ETF, but that also makes it a riskier investment option.

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.

Definition and Examples of a Leveraged ETF

A leveraged ETF is a type of exchange-traded fund that tries to outperform the underlying asset that it tracks, usually by producing two to three times the return of the correlating asset.

  • Alternate names: Geared ETF, geared ETP

For example, 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 two to three 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
  • Futures

In other words, leveraged ETFs can be tied to different industry sectors, commodities, or currencies, just as regular ETFs can be. However, while they seek to present better returns than the index they track, their inclusion of riskier assets like options, forward contracts, swaps, and futures meant that leveraged ETFs present more risk than a regular ETF.

For example, over the course of a few months, an index could rise by 2% but the leveraged ETF that tracks it could fall by 6%. This is due, in part, to the fact that leveraged ETFs reset daily—the goal is to outperform the market on a daily basis. So, you could see a lot of volatility over time, whereas the index the leveraged ETF tracks will likely be far less volatile. And because leveraged ETFs reset daily, they can lead to bigger losses in volatile markets that you may not experience with the index the ETF tracks.

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.

Because leveraged ETFs are more complex and volatile than regular ETFs, they're not recommended for beginning investors.

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:

  • DDM–ProShares Ultra Dow30 ETF
  • SSO–ProShares Ultra S&P500 ETF

Key Takeaways

  • 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.

Article Sources