Leveraged ETFs can greatly amplify returns. What's the catch? They also amplify losses and perform poorly in the long run. Everything you need to know about these funds.
The universally-cited gospel of investment is that high-risk strategies have the potential to yield correspondingly high rewards. This proves especially true for leveraged ETFs, or leveraged exchange-traded funds, which are high-risk investments with the capacity to generate significant capital gains.
Incorporating leveraged ETFs into an investment strategy can prove both alluring and daunting, and an appreciation for their value begins with an understanding of the unique financial and institutional mechanisms that they run on.
Like traditional ETFs, leveraged ETFs are securities that allow individuals to invest in underlying indices, like stock indices, commodities, or bonds. However, where traditional ETFs invest in securities on a 1:1 basis, leveraged ETFs use financial derivatives to create a ratio, or the “leverage,” by which investors can invest in securities at higher ratios.
This might sound complex, but it’s not: much like a lever amplifies a force into something greater in magnitude, leveraged ETFs amplify returns using their given ratio. Leveraged ETFs utilize forms of leverage, such as debt, futures, options, and other financial instruments in an effort to yield these higher returns. This makes leveraged ETFs both deeply lucrative and incredibly risky; potential gains are multiplied, but potential losses are, too.
Leveraged ETFs, as mentioned earlier, magnify returns on underlying indices—such as the NASDAQ-100, Dow Jones, and S&P 500 index—using a ratio, or “multiplier,” to amplify changes in value. This makes them opportunity-rich investments with high growth potential. The easiest way to understand the function of a leveraged ETF is by way of example; let’s take a look at the Direxion Daily Financial Bull 3x Shares (FAS) ETF, a popular triple-leveraged ETF that tracks the Russell 1000 index.
The ETF’s major securities include institutions such as Visa (V), Berkshire Hathaway (BRK.B), and JP Morgan Chase (JPM). As the name suggests, the fund intends to triple returns from the index for its investors.
If an investor invests $1,000 in the ETF and the stocks tracked from the index rise by 2%, the ETF returns 6% in that period. This means that the investor earns $60. On the other hand, if the underlying index declines by 4%, the FAS registers a loss of 12% for that period, costing our investor $120.
Movements in the underlying assets within a given fund are continuously compounded on a daily basis in a leveraged ETF, allowing issuers to amplify returns from the stock market while owning the same tickers as a traditional fund.
The traditional ETF will have returns equal to those of their underlying indices, meaning the fund performs exactly as well as its assets do. Leveraged ETFs, however, are riskier investments, in that they return a multiplier of the fund’s own returns. While this is advantageous to investors who have correctly selected a leveraged ETF, it also means that losses are returned at an exponentiated rate, putting an unlucky investor at risk for substantial losses if their ETF underperforms.
However, for an investor whose portfolio is full of (or built around) short-term risks, leveraged ETFs can make a promising investment. For an investor well-versed in financial analytics, with capital to spare, leveraged ETFs—which can promise massive returns and quick turnarounds—are a veritable goldmine for two reasons:
As with any ETF—and any investment at all, really—there are management and transaction fees associated with leveraged ETFs.
While the existence of these fees and expense ratios aren’t unexpected, leveraged ETFs typically entail higher fees than traditional ETFs for two reasons:
Trading on margin involves using a broker to lend money to a customer so that the borrower can purchase stocks or other securities; on top of this expense, brokers will often charge interest on these loans. Purchasing a leveraged ETF is an example of trading on margin, introducing a new associated expense.
As risky investments, leveraged ETFs have many pros and cons that you should be aware of before considering investing in them.
Leveraged ETFs offer potential gains that can be much larger than investing in the same ETF. If analyzed correctly, a leveraged ETF can reap substantial returns for their investor in the short term, since they amplify returns using derivatives.
Therefore, if an investor is confident about the success of a given fund, they can use a leveraged ETF to build their wealth at an unprecedented rate.
Leveraged ETFs provide the investor with a variety of options with respect to trading their securities. Owning a fund provides diversification for the investor, and allows them to avoid potential turmoil in a given market.
If the tech sector were to collapse as a result of stringent regulatory mandates, for instance, investors in a fund would only lose the portion of their fund invested in tech, rather than an entire portfolio invested in that industry.
Inverse ETFs allow investors to make money, even when the market is down. An investor chooses an inverse ETF if they think the underlying asset will decrease in value. If they are correct, they can actualize returns while everyone else in the market is losing money. Had the investor chosen to purchase a traditional ETF on those same securities, they would lose money when it underperformed.
Instead of yielding returns according to the movements of the underlying market, leveraged inverse ETFs can increase returns on a 2:1 or 3:1 basis.
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While leveraged ETFs can lead to higher gains, they can also lead to significant losses, greater than those associated with non-leveraged ETFs. There are two sides to every coin, and leveraged ETFs are no different—just as gains are amplified, so are losses. Investors with small amounts of available capital may lose it all in the blink of an eye—or the click of a stock ticker.
Leveraged ETFs have higher management fees and expense ratios than traditional ETFs. The higher fees associated with leveraged ETFs are a product of more involved management, which allows the fund's investors to feel secure that someone is actively overseeing their investments. For some investors, however, these fees may outstrip the returns of leveraged funds, making them non-viable investments.
Leveraged ETFs can perform poorly in the long-term, and don’t always return steady gains over time. In being susceptible to market volatility, and mercurial in their long-term returns, leveraged ETFs can prove to be imprudent long-term investments.
The liquidity of a leveraged ETF is comparable to other funds. Decreased liquidity characterizes the investment objective of a leveraged ETF as long-term in nature. Despite this, leveraged ETFs are typically considered short-term investments. Investors’ inability to sell the fund at any point in the day means that they will likely need to track daily returns and analyze the fund's underlying securities as frequently as possible.
As with all other forms of investment, leveraged ETFs are context-dependent—they’re only valuable if they work for you. It’s important to analyze your decisions and ensure that your investments are aligned with your ultimate financial and wealth goals, whatever those may be.
Leveraged ETFs may generate immense wealth for some, but also have the capacity to ruin portfolios for others. As with everything else, what matters most is a strong grasp of the nuances of high-risk investments—and an understanding that the promise of high-yield returns doesn’t always guarantee them.
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