Leveraged ETFs: Worth It or Not?

An exchange-traded fund is a type of investment product that should be registered with the US Securities And Exchange Commission (SEC) under the Investment Company Act of 1940. It can be registered as either a unit investment trust or an open-end investment company (commonly known as funds).

Investors use different strategies in an attempt to benefit from the overall performance of the stock market. This includes leveraged ETFs, which can offer two to three times higher returns compared to a traditional ETF.

However, the alluring potential of a higher return also makes it a riskier investment option. Some investors also use leveraged ETFs for tactical allocation. Before you decide if this investment strategy option suits you, here's what you need to know.

What Is a Leveraged ETF?

A leveraged ETF (Exchange-Traded Fund) is a marketable financial security that uses borrowed money, debt and financial derivatives (such as futures and options contracts). Derivatives like options contracts are used to magnify the leverage exposure of an underlying index. Non-leveraged ETFs, on the other hand, hold only the equity of shareholders and track an underlying leveraged asset class or leveraged index by matching that asset or index's daily performance.

Leveraged ETFs' fund managers focus on generating daily returns that are multiples of the asset class or underlying index's performance to earn returns that exceed the correlating investment. Generally, leveraged ETFs are designed to provide 2-3 times the return of the correlating asset if the market moves as expected. For example, if the tracking target increases by 1%, the leveraged ETF will yield a 2% return on investment (ROI).

How Do Leveraged ETFs Work?

Like regular Exchange-Traded Funds, a leveraged ETF is tied to different commodities, industry sectors or currencies and generally operates with an arbitrage mechanism. It is a collective investment fund, where a great deal of investors' money is merged into one investment. They are designed to increase the short-term performance of a particular index, commodity or stock market. Similar to stocks, leveraged ETFs also trade on exchanges with a live market price.

The majority of leveraged ETFs are double-leverage, but there are few groups with triple-leveraged ETFs.

It's also possible to profit by shorting; doing so allows investors to generate returns when the price decreases.

It's important to remember that leverage is determined daily, and the returns will not usually double or triple the underlying index for any period. To achieve the return and get the expected leverage, investors and traders have to rebalance daily. The underlying benchmark resets daily to maintain the leverage ratio. Because of this, the volatility of the index can eat away at the gains, a phenomenon known as volatility decay.

Benefits of Leveraged ETFs

The potential for high returns is the most attractive benefit leveraged ETFs offer. Their ability to outperform the underlying index by 2-3x daily offers significant rewards. 

Inverse leveraged ETFs can also offer major returns. They can buy short even if the market index is falling. The high liquidity of the underlying index can also allow full replication.

Risks of Leveraged ETFs

Since leveraged ETFs are derivative products with high potential for returns, they are also high-risk investments. Leveraged ETFs are designed to create multiple returns on an everyday basis. However, it won't always generate a return that high. For example, if an index has a yearly return of 3%, the leveraged ETF may not return 6% because the profit will be more in the direction of daily returns throughout that year.

Pros and Cons of Leveraged ETFs

Like other financial instruments, leveraged ETFs also have their strong and weak sides.

The Costs of Leveraging

Below are some costs you can expect when you invest in leveraged ETFs:

• Dealing fees - These are the cost of buying and selling ETFs through a broker or an investment platform. Most brokers charge a flat rate per trade, and costs can increase quickly, especially when trading in smaller amounts.
• Management fees - This is the amount you pay for the ongoing management of your leveraged ETF, which is taken from the amount invested. It can be seen on the Key Investor Information Document (KIID) or the factsheet.
• Rollover costs - Rollover costs are the transaction fees and interest charges resulting from daily rebalancing. To rebalance your leveraged ETFs, it is necessary to enter and exit derivative contracts continuously.
• Taxes -Once you receive your dividends, you will need to pay taxes on the gains.

Performance of Leveraged ETFs

Generally, the daily compounding of leveraged long ETFs can result in increasing percentage gains in a rising market and decreasing percentage drops in the falling market. 

Rising Market

If an index rises for several days, it will translate to faster ETF growth as the value of the index increases. For long leveraged ETFs, it will outperform the expected goal in the rising market.

Falling Market

For a long leveraged product, if the market falls, the leveraged ETF will underperform. The continuous downward movement will significantly drag the long-term performance of the ETF.

Flat and Volatile

Flat and volatile markets are the results you can see if you hold a leveraged ETF position for more than a day. In a flat and volatile market, the market performance can rise by 10% today, fall by 10% tomorrow, then increase by 10% the next day. If the timing and positioning of your leveraged ETF are correct, this can be a benefit for you.

  Example of a Leveraged ETF

Let's take the FTSE 100 index or the price of gold as an example. 

A double-leveraged ETF is designed to return two times the daily return of the FTSE 100. So, if the index goes up by 5%, the ETF will go up by 10%. If the index goes down by 5%, the ETF will also go down by 10%. This is an example of a long position.

Conclusion

Investors use leveraged ETFs for short-term moves in the market, and these assets can lead to gains or losses of money very quickly. Predicting which way the market will move is a skill you'll develop over the course of your investing. All in all, investing in leveraged ETFs depends on your risk tolerance.

Since you already know what leveraged ETFs are, their pros and cons, you can use this knowledge and practice on the Libertex demo account to hone your skills and prepare for live trading and investing.