Tuesday, 28 May 2024

What Are Leveraged ETFs?

What Are Leveraged ETFs?
26 Jan
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Investors on the hunt for the best exchange-traded funds (ETFs) often turn to leveraged ETFs because they promise — and sometimes deliver — higher returns. Here’s how the best leveraged ETFs work and what you need to watch out for when you’re using them to invest.

Leveraged ETFs explained

A leveraged ETF is a fund that aims to magnify the returns of the index tracked by the fund. Depending on the fund’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. It’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:

  • The S&P 500
  • The Dow Jones Industrial Average
  • The Nasdaq 100

While those are three of the largest indexes, they aren’t the only ones leveraged ETFs are based on. Other popular indexes include the following:

  • The Russell 1000 Financial Services Index
  • The NYSE Arca Gold Miners Index
  • Dow Jones U.S. Oil &Gas Index

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 “spider.” 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.

How leveraged ETFs work

So how exactly do leveraged ETFs manage to double or even triple the daily return of their benchmarked index? It’s through a complicated process that uses debt and financial derivatives, such as futures or swaps, to mimic the index’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 — though mutual funds still have many benefits.

Magnifying returns

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 investors’ capital. For example, on a double-return ETF, the fund is levered 2-to-1. This means the manager uses one dollar of investors’ money and one dollar of debt. On a triple-return ETF, the manager uses one dollar of investors’ 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 fund’s exposure to the index in order to track its performance. Managers are buying new exposure to the index continually, and this “rolling” of contracts increases transaction costs.

Bullish and bearish funds

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.

Best for short-term investors

Perhaps the most important thing to understand about leveraged ETFs is that they’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 they’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%. It’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%. It’s a 3x fund that provides triple leverage on the Nasdaq composite — 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.

Risks of investing in leveraged ETFs

There’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:

  • Upside is magnified, but so is downside: The promise of double or triple the index’s move is appealing, but it comes at the cost of the same downside if the index moves against you. So a 1% move down could cost you 2% or 3%. That’s the most obvious price of aggressively betting on a higher return.
  • Tracking error: Tracking error occurs when a security’s price doesn’t follow the index it was meant to track. Because of the costs of rolling derivatives daily and management fees, leveraged ETFs often don’t entirely fulfill their promise of delivering double or triple returns.
  • Fund prices tend to degrade over time: Closely related to tracking error, the prices of ETFs tend to degrade over time. Leveraged ETFs are meant to be held for a day or less to capture the performance of the index, not longer. As an index gyrates over time, the ETF’s price can fall. Here’s how it works.

    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 — even the best leveraged ETFs — are not intended for buy-and-hold investors.

  • They’re expensive: While the expense ratios of many top ETFs have plummeted to very low levels (think fees of just 0.03%), the price of leveraged ETFs remains high. An expense ratio of around 1% is quite common. Even the lowest-cost leveraged ETFs don’t get much cheaper than about 0.4%, and it’s only a handful of funds at that level. That’s another reason most investors don’t stick around in these ETFs for long.

Bottom line

Leveraged ETFs can offer the promise of double or triple the daily return of their benchmarked index, but investors should be careful that they’re using the ETFs as they’re intended — 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.

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James F. Royal, Ph.D.


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Source: https://www.magnifymoney.com/blog/investing/best-leveraged-etfs/

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