What is Leveraged ETF?
Leveraged exchange-traded fund (ETF) is a financial product that uses leverage (debt borrowings) in order to finance investments in financial instruments like derivatives with the objective of multiplying the returns of the underlying index. Leveraged exchange-traded funds are currently available on major recognized exchanges like Dow Jones Industrial Average (DJIA) and Nasdaq 100 etc.
Example of Leverage Exchange-traded Funds
Assume Proshares Ultra ETF invests in the securities of US-based financial companies by tracking the S&P 500 financial services index. ETF holds around $1.0bn assets under management and the expense ratio is 2%. The objective of ETF is to achieve returns of 2 times the return of the financial index.
If the trader holds the position in the ETF by $10,000 and the underlying S&P 500 index moves up by 1% then the ETF would produce a return of 2% during the same period. If the underlying index falls by 2% the ETF will have to face a loss of 4% during that period.
Understanding the Leverage Exchange Traded Funds
Leveraged ETFs have gained extraordinary popularity across various media including individual and institutional investors. In the current scenarios, there are a number of leveraged ETFs in the market spreading and include various assets class and industries. Among them are mostly double leveraged and triple leveraged ETFs at the same time.
- For professional and institutional investors leveraged ETFs are a very important tool to gain in short term tactical and statistical strategies and for individual investors to leverage ETFs are instruments to make the higher returns with market movements.
- Leveraged Exchange Traded Funds that track DJIA (Dow Jones Industrial Average), Nasdaq 100 or S&P as an underlying index use financial products and debts securities that amplify every 1% positive gain to 2% or 3% gain in the respective index. The amount of gain on the Leverage ETFs depends on the leverage being used in the ETFs. The term leverage is the process in which borrowed funds are used to buy or long on future and options to magnify the impact of price movements.
- What happens if the underlying index moves in the opposite direction which means that investors stand to lose their money if an underlying index falls by 1%, the extent of losses could be magnified by the leverage. In such scenario leverage, ETFs could turn out to be double edge sword in the sense that it can lead to significant gains provided underlying index moves in a positive direction while in other cases it could lead to face investor’s significant losses if underlying index moves in opposite direction.
Investors should pay heed to the risk before they park their funds in leveraged ETFs as the extent of losses in leveraged Exchange Traded Funds is higher as compared to traditional investments. The existence of management fees and administration costs could further reduce the potential returns on the leverage ETFs.
Leverage in Leveraged ETFs
Leverage ETFs strives to amplify exposure to an underlying index with the help of future and options contracts. It does not mean that leveraged ETFs are magnifying the annual returns of the respective index instead leverage ETFs are marked to market on a daily basis and this process helps in producing the daily results. Over a long period of time, the impact of compounding marked to market could potentially differ between the performance of funds and the underlying index.
Options contracts by their very nature provide their holder options and no obligations to buy or sell the underlying security at an agreed price on or before the expiry date. The writer of option charges a holder of options an upfront charge called premiums which allows the holder of options to go long on a large number of stocks or securities. Therefore the options combined with investments in underlying stocks would further add to the gains on holding the securities. In the same way, the leverage ETFs use the options contracts to add to the potential gains of holding the traditional investment in ETFs.
Inverse Leveraged ETFs
In inverse leverage, ETFs investors make the money when the underlying index moves in the opposite direction or when underlying security or index decline in value. An inverse leverage ETFs rises when underlying security falls in value resulting in gains for the investors to make a profit from the bear market.
Cost of Leverage Exchange Traded Funds
In addition to the above-mentioned charges like management fees and administration charges associated with an investment in leveraged ETFs, there are other costs being involved in managing the leveraged ETFs. Leveraged Exchange Traded Funds are considered more expensive as compared to non – leveraged ETFs the reason being, for instance, to enter into options contracts holder is supposed to shell out upfront charges in the form of premiums as well as the cost of borrowing and margining. Most of the leveraged Exchange Traded Funds are considered to have an expense ratio of 1% or more.
Short term vs Long term Investment Strategy
Traders and investors use leverage ETFs to make the money by speculating on the short term movement of stock prices. Investors avoid using the leverage ETFs as a long term investment strategy due to the higher cost of Leverage ETFs and high risk.
For instance options, contracts have an expiry date which is short term in nature and are traded in the short term as well. For traders and investors, it is not possible to hold an investment for the longer term as the leverage ETFs are created with the help of options contract which has short term maturity or expiry. Therefore trader and investors hold the positions in leveraged ETFs for the short term if they hold the positions for a longer period the returns would differ from an underlying index.
Merits and Demerits of Leverage Exchange-traded Funds
Some of the merits and demerits of Leveraged Exchange Traded Funds are as follows.
Following are the merits of leverage exchange-traded funds:
- The major benefit of trading and investing in leveraged ETFs are the potential profits that could exceed the underlying index.
- The traders and investors have a number of securities to choose to trade in leveraged Exchange Traded Funds.
- Traders can also benefit in inverse leverage exchange trading funds when the underlying index falls in value.
Following are the demerits of leverage exchange-traded funds:
- If the value of underlying index declines then the leveraged exchange-traded funds could make the investors face significant losses.
- The leverage exchange-traded funds are expensive due to higher management fees and operational charges.
- Leveraged exchange-traded funds are short term market investment strategy investors cannot use the leverage exchange-traded funds for the long term investments.
- Leveraged exchange-traded funds use financial instruments like derivatives to generate returns by tracking the underlying index.
- Leveraged ETFs are the short term market investment strategy to gain through price movement of the underlying index.
- Traditional investment in ETFs used to track an underlying index on face to face basis while leverage ETFs generally aim for 2 times or 3 times the underlying index.
- It works like double-edged swords in the sense that if the underlying index moves in a positive direction they can exceed the gains multiple times the movement in the underlying index and vice versa.
This has been a guide to Leveraged Exchange Traded Funds. Here we discuss the example, cost, and inverse of Leveraged ETFs along with merits and demerits. You can learn more about financing from the following articles –