An exchange-traded fund (ETF) that employs financial derivatives and debt in order to magnify the returns of theunderlying index is known as a leveraged exchange traded fund. When compared to other types of ETFs, they have higher risk and return characteristics.
A conventional ETF strives to replicate the index's returns over time, whereas a leveraged ETF seeks to double or triple the index's daily returns.
In this article, we will talk about the properties of leveraged ETFs as well as their applicability.
How Do Leveraged ETFs Function
Leveraged exchange-traded funds operate in a manner that is distinct from that of traditional ETFs. Rather than merely replicating the performance of the underlying index, leveraged ETFs make an effort to magnify the daily returns of a benchmark index by, for example, doubling or tripling those returns. Leveraged exchange-traded funds (ETFs) borrow money in order to increase their returns and then utilize that money to acquire derivatives like futures and options contracts.
For instance, a standard exchange-traded fund that follows the Nasdaq index will attempt to purchase and maintain an equal number of index shares in order to provide a return that is proportional to that of the index. In contrast, it is possible for leveraged ETFs to aim for returns with a ratio of 2:1 or 3:1.
Investors who are interested in acquiring leveraged ETFs should be aware that the purpose of these products is not to strive to magnify the long-term returns of a benchmark but rather the daily returns of a benchmark. This is because the leverage magnifies the loss if the underlying index declines. Thus, leverage is dual-sided since it may lead to both substantial benefits and losses. The risk of loss connected with leveraged ETFs is significantly larger than the risk involved with regular investing. Additionally, the management and transaction fees associated with leveraged ETFs might diminish the attractiveness of the fund.
Most leveraged ETFs aims to magnify the returns of a benchmark index by a factor of two or three:
- Double Leveraged ETF, also known as 2x leveraged ETF, aims to double the index's daily returns.
- Triple Leveraged ETF, also known as 3x leveraged ETF, aims to triple the index's daily returns.
Assume, for instance, the case of a double leveraged exchange-traded fund (ETF) in which the benchmark moves from 100 to 105 (a 5% increase).
Therefore, a yield of 5 (or 5%) would be expected from the benchmark ETF. On the other hand, the return would be magnified for the leveraged ETF in the following manner:
- Initial $100 + (($100 x 5% index return) x 2) = $110.
It goes without saying that this also applies to losses. Therefore, investors need to exercise extreme caution when dealing with these products because, depending on the state of the market, they might result in significant losses.
Inverse exchange-traded funds were developed specifically for the situation that was just outlined – They generate positive returns when the related benchmark declines. A wide variety of leveraged options are available.
Generally, the derivatives used to provide leverage in leveraged ETFs are not long-term investments. Traders often retain leveraged ETF holdings for a few days. Long-term results from leveraged ETFs may drastically differ from the index of reference.
Pros and Cons
Traders that desire to bet on an index or capitalize on the short-term momentum of an index often utilize leveraged ETFs – They are rarely utilized as long-term investments due to the inherent high risk and high expense associated with their structure.
- Possibility for greater profits that are greater than those of the underlying index.
- Access to derivatives, including as options and futures contracts, often unavailable to the majority of investors
- Substantial opportunities when the market is falling.
- Access to a vast array of different assets.
- High liquidity, easily tradable
- Potential for far greater losses than the index they track.
- Fees and cost ratios associated with leveraged ETFs are often more expensive than those associated with regular ETFs.
- Not suitable for long-term investing.
Leveraged ETFs, higher costs incurred
There are a variety of charges that may be connected with leveraged exchange traded funds. These costs may include management fees, transaction fees, and other expenditures. Because premiums have to be paid to acquire the option contracts, as well as the cost of borrowing, or margin, leveraged exchange-traded funds have greater expenditures than traditional ETFs. A significant number of leveraged exchange-traded funds have cost ratios of 1% or higher.
It is worth noting that despite the fact that leveraged ETFs have very high-cost ratios, they are frequently cheaper than other types of margin-based products. For example, short selling, which includes borrowing shares from a broker in order to place a bet on the price going down, may result in a charge that is at least 3% of the total quantity of shares that are borrowed. Furthermore, when purchasing stocks on margin, investors run the risk of incurring additional costs and be subject to margin calls if the position starts to decrease. As a reminder, a broker may issue what is known as a margin call if the value of the collateral securities falls, which is a request for more funds to be deposited into the client's account.
The Bottom Line
In conclusion, leveraged ETFs are intrinsically riskier than standard ETFs. With leveraged ETFs, investors may experience enhanced profits, but decreases in value are also magnified. In addition, due to their structure, the value of these instruments often depreciates over time. Thus, leveraged ETFs are often unsuitable for long-term investments and are best suited for short-term traders. Before committing to these financial products, investors are urged to conduct thorough research and fully comprehend their scope.