Investors on the hunt for the best exchange-traded funds (ETFs) often turn to leveraged ETFs because they promise â€” and sometimes deliver â€” higher returns. Hereâ€™s how the best leveraged ETFs work and what you need to watch out for when youâ€™re using them to invest.
A leveraged ETF is a fund that aims to magnify the returns of the index tracked by the fund. Depending on the fundâ€™s objective, it attempts to provide two or three times the daily return of its benchmark. For example, if the fund benchmarks the S&P 500 index and the index rises 1% on a given day, a leveraged ETF aiming to triple that performance wants a 3% return. Itâ€™s ambitious, and these funds are the playground of aggressive short-term investors.
Leveraged ETFs are typically benchmarked against an index fund, and many of the most widely traded leveraged equity ETFs often track the following indexes:
While those are three of the largest indexes, they arenâ€™t the only ones leveraged ETFs are based on. Other popular indexes include the following:
So leveraged ETFs give investors a way to wager on the daily returns of some of the hottest areas, including stocks, gold, oil and banks.
ETFs have been a popular way to invest in the stock market since the first one was introduced in the U.S. in 1993. It was based on the S&P 500 and was called the SPDR, which investors soon referred to as â€śspider.â€ť From there, the market skyrocketed, and a couple of decades later, ETFs numbered more than 2,000. The first leveraged ETF was introduced by ProShares in 2006, and by early 2019, there were more than 220 leveraged ETFs trading on American exchanges.
So how exactly do leveraged ETFs manage to double or even triple the daily return of their benchmarked index? Itâ€™s through a complicated process that uses debt and financial derivatives, such as futures or swaps, to mimic the indexâ€™s performance, instead of owning the index directly, in order to juice returns. This kind of innovation has led to the growing popularity of ETFs over more traditional mutual funds â€” though mutual funds still have many benefits.
To magnify returns, a leveraged ETF buys futures on its index using leverage. That means the ETF is buying two or three times the exposure to the index, or more than it would be able to afford with only its investorsâ€™ capital. For example, on a double-return ETF, the fund is levered 2-to-1. This means the manager uses one dollar of investorsâ€™ money and one dollar of debt. On a triple-return ETF, the manager uses one dollar of investorsâ€™ money for every two dollars of debt.
So when the index moves, the leveraged ETF moves even more because it actually owns more exposure to the index due to the use of debt.
Because derivatives expire, the manager has to be active in the market, constantly maintaining the fundâ€™s exposure to the index in order to track its performance. Managers are buying new exposure to the index continually, and this â€śrollingâ€ť of contracts increases transaction costs.
Leveraged ETFs can mimic the performance of rising stocks but also falling stocks. A triple-leveraged ETF that bets on rising stocks might be called the S&P 500 3x Bull, while its counterpart might be called the S&P 500 3x Bear.
Sometimes, these leveraged bear funds are called inverse or ultrashort funds. The prices of these bearish funds rise when the benchmarked index falls.
Perhaps the most important thing to understand about leveraged ETFs is that theyâ€™re set up to track the daily performance of an index, not its performance over a longer time frame. Leveraged ETFs can perform poorly for long-term investors, with their price degrading over time because of how theyâ€™re structured. Leveraged ETFs are best for short-term investors.
One of the most popular leveraged ETFs is the ProShares UltraPro S&P 500, with an expense ratio of 0.92%. Itâ€™s a 3x fund, providing triple leverage on the S&P 500 index. The ETF has more than $1.1 billion in assets under management, and its holdings comprise financial derivatives called swaps and equity stakes in the actual companies composing the S&P 500.
Another popular leveraged ETF is the ProShares UltraPro QQQ, with an expense ratio of 0.95%. Itâ€™s a 3x fund that provides triple leverage on the Nasdaq composite â€” a tech-heavy index. The ETF has more than $3.5 billion in assets under management, and its holdings comprise swaps on the Nasdaq and equity stakes in the actual companies composing the Nasdaq 100.
Thereâ€™s no such thing as a free lunch, and if leveraged ETFs offer the potential for higher returns than an index, they also present other risks to investors. Here are some of the largest:
Imagine a double-leveraged ETF priced at $100. If the index moved 10% in one day, the ETF would move up 20% to $120. Now if the index dropped back to its original price (-9.1%), the ETF would decline by 18.2% to $98.16. While the index remains at its initial price, the ETF is actually down a total of 2.84%. As the index gyrates or leverage becomes higher, this difference becomes greater.
Leveraged ETFs â€” even the best leveraged ETFs â€” are not intended for buy-and-hold investors.
Leveraged ETFs can offer the promise of double or triple the daily return of their benchmarked index, but investors should be careful that theyâ€™re using the ETFs as theyâ€™re intended â€” only on a daily basis. And buying and selling an investment within a day seems much more like gambling than true investing. Despite so many drawbacks of leveraged ETFs, investors continue to find them attractive as short-term investing vehicles.