Leveraged exchange-traded funds are a type of ETF that use financial derivatives and debt to amplify the returns of an underlying index. For example, if you were to invest in a 2X leveraged ETF on the S&P 500, it would double your profits if the S&P 500 rose or halve them if it fell. But these securities aren’t without risks; this amplified exposure can result in losses that far exceed those experienced by investors who don’t use leverage at all. In this article, we’ll explain how these complex investments work and what they mean for your portfolio.
Exchange traded funds
Exchange traded funds (ETFs) are a type of mutual fund that trades like a stock. Investors can buy and sell ETFs throughout the day, which allows them to get exposure to large markets with minimal investment costs.
The most widely known ETF is probably the S&P 500 index, which tracks the performance of 500 large US companies. But there are thousands of other types of ETFs that track everything from gold bullion prices to obscure stock indices in small countries around the world.
Leverage
Leverage is the use of borrowed money to amplify returns. This can be done by using margin, which allows investors to borrow up to 50% of their account value for stock purchases and 200% for options trading. Leveraging an investment makes sense when you think about why it’s used: leveraged ETFs allow investors who don’t have enough money in their accounts to make big bets on stocks without having to cash out some investments first.
Leverage works like this: let’s say that you want to invest $1,000 in a company’s stock but don’t have enough cash on hand (or believe the company will pay off). You could borrow $450 from your bank at 5% interest annually, then invest that $450 plus your own capital ($550 total) into the stock at its current price — say $100 per share. If it goes up 10% over the next year while paying its dividend (5%), then after repaying your loan with interest and adding in those dividends as well, your return would be 15%. If instead it went down 10%, then you’d only lose half as much (5%) because there would only be one dollar out of every two invested instead of all four dollars going into play during losses or gains alike.
Long vs. short ETFs
A leveraged long ETF is designed to profit from an increase in the value of the underlying asset. A leveraged short ETF is designed to profit from a decline in the value of its underlying asset, also known as its benchmark index or target.
A long ETF is often referred to as a bull fund, while a short ETF is sometimes called a bear fund.
ETF structure
An ETF is a type of fund that is traded on an exchange. The term “exchange-traded” means that ETF shares are bought and sold at any time during the trading day, much like stocks. This structure allows you to buy or sell your investment at any time, just as you would with a stock.
ETFs can be actively managed or index-based. In an active management strategy, an investment manager tries to outperform a benchmark index (such as the S&P 500) by investing in securities that he or she believes will do better than those included in the index over time. An index fund’s portfolio tracks its chosen benchmark without trying to beat it through trading strategies or other attempts to predict market movements (which can result in higher fees).
An ETF generally holds assets such as stocks or bonds within its structure; however, some ETFs also hold other types of financial instruments such as commodities (e.g., gold).
Structure of leveraged ETFs
Leveraged ETFs are structured as a long position in an index and a short position in a financial derivative. The derivative is a contract that provides leverage to the underlying index. For example, if you invest $1,000 into an unleveraged ETF that tracks the S&P 500, you’ll own 100 shares of each of the 500 stocks in the index. If you invest $100 into an inverse leveraged ETF that tracks the same index, however, then you’ll own only 50 shares of each stock—but those 50 shares will have equal dollar value to 100 shares from an unleveraged fund.
In this way, leveraged ETFs can be thought of as being similar to options—with two key differences:
- Leveraged ETFs use futures contracts instead of options.
- Leveraging is based on ratios rather than percentages.
The first difference means that leveraged ETFs are more likely to be exposed to price changes in the underlying asset, while options use leverage based on percentages. For example, if you buy a call option for $5 and the stock goes up by $1 then your position will be worth $10. However, if you invest $5 directly into an index and it rises by $1 then your position will be worth $10 as well.
The second difference is that leveraged ETFs are based on ratios rather than percentages. For example, if the S&P 500 goes up by 10% then an unleveraged ETF will go up by 10%. However, if you invest in a 2x leveraged ETF then it will rise by 20% instead.
Exposure to S&P 500
In order to track the S&P 500 as closely as possible, leveraged ETFs are designed with a multiplier that is usually two or three times the index’s return. As an example, if you invest $1,000 in an S&P 500 ETF (that tracks the index) and it gains 2%, then you will have made $20. If you had invested in a 2x version of that same ETF, your total return would be 4%. In other words, the leveraged version would give investors double the exposure to stocks than they would have received by investing directly into stock indexes.
As explained previously, these types of funds are designed to give investors more exposure when markets have gone up and less exposure when markets have gone down. They are not intended for long-term investments because their daily returns can fluctuate wildly—even over longer periods of time—and they often fail during market downturns due to their high volatility.
Risks of leveraged ETFs
Leverage can magnify gains and losses, which is why you should be careful when considering the risks associated with leveraged ETFs.
- Losses can be magnified: If the price of an underlying asset falls, a leveraged ETF will lose more than its non-leveraged counterpart. For instance, if you held $10,000 worth of an S&P 500 index fund with 2x leverage and your investment lost 5% over a period of one year, you’d lose more than $500; in fact, it would actually be closer to $1,000! As such, this strategy may not appeal to risk-averse investors or those who are looking for steady growth over time.
- Gains can also be amplified: If an underlying asset rises in value by 10% during a given period (a common goal for many investors), then your investment would rise 20%. For example: A $10k investment would turn into $12k when using 2x leverage—more than double what it would have been without leverage.
Leveraged exchange-traded funds (ETFs) are stock funds that use financial derivatives and debt to amplify returns of an underlying index. Learn about the risks and rewards of investing in these complex securities.
Leverage is the use of borrowed money to increase the potential return on an investment. In the case of leveraged ETFs, the use of financial derivatives and debt allows you to double or triple the daily performance of an index.
ETFs are interests in a collective investment scheme which can be traded on an exchange like stocks. Unlike mutual funds, which pool together investors’ money and invest it in stocks or bonds with their own capital, ETFs trade like individual shares (which means they don’t require investors to maintain minimum investments). Because they track indices rather than trading individual securities, ETFs generally have lower expenses than traditional mutual funds—and none of that pesky management fee.
In this article, you’ve learned the basics of leveraged ETFs and what they can do for your portfolio. They allow you to amplify returns while taking on more risk than normal—but they also come with some drawbacks. The biggest downside is that your gains may not match those of the underlying index over time; if you invest in a leveraged fund such as S&P 500, it’s possible that the returns will be lower than expected. This is because of how these products work: although they track an index, their performance isn’t exactly the same as tracking it directly; instead, there are other factors involved besides just buying and selling shares like normal traders would do on their own accord.
