Leveraged ETFs are among the most misunderstood and controversial investment products in Canada. Leveraging can be a great tool for investors who know what they’re doing, but it’s not something that everyone should use or even consider using. In this article, we’ll explain how leveraged ETFs work—and what you need to know before investing in one. We’ll also give examples of leveraged ETFs that are available today so you can see how they work with real-world examples.
How does a leveraged ETF work?
Leveraged ETFs are a type of fund that uses derivatives to amplify the returns. A derivative is a financial instrument whose value is based on another asset, such as an asset’s price or interest rate. For example, if you wanted to buy an ETF that tracks the price of gold and you only have $100 to invest, but you expect the price of gold to rise by $20 over night then you can use leverage to multiply your investment so that it grows by $200 overnight.
The way this works is that the leveraged ETF will borrow money from other investors who are willing to lend their money out at high interest rates (usually 0-2%). Leveraged ETFs typically pay back these loans within 2 years after they were made using funds from other investors or through fees charged by exchanges where they trade.
Does a leveraged ETF use leverage?
A leveraged ETF uses derivatives to magnify the performance of an underlying index. When you buy a stock or fund, you’re purchasing ownership of a company. An ETF is different—with an ETF, you’re buying shares in a pool comprised of multiple securities that are designed to replicate the performance of an underlying index.
For example, if the S&P 500 Index increased by 1% on any given day during a year when there were two up days and two down days, then it would return 2%. If you were invested in this market through an S&P 500 Index Fund, your investment would experience that same 2% increase; however, if this same increase occurred with one up day and three down days (or vice versa), then your returns would fall short at only 0.6%. That’s why many investors choose to use leveraged ETFs instead: they believe these funds will help them realize larger gains than standard funds without exposing them to undue risk or volatility due to their use of derivatives—which we’ll talk about more below.
What is gearing?
Gearing is the more traditional way of borrowing to invest, and it can be used to magnify returns or losses. If you use gearing, then you will have more money at risk if your investment goes up or down. For example, say you put $100 into a leveraged ETF that aims to double the performance of an index. If the market moves down by 10% before interest costs are taken into account (and assuming no other fees), then your investment will drop by 20%.
If you use gearing with an ordinary fund such as a stockmarket tracker fund, then this means buying shares knowing that if share prices fall anywhere near what they were when you bought them (or even just one day after), your shares could be worth less than when you bought them and so would lose value again as well as falling in price due to market movements over time.
The second way of borrowing to invest is through a ‘margin loan’. This means that you have a loan against the value of your portfolio, and any profits are paid out to you as normal dividends or interest payments. When prices fall below what they were when you first bought them (or even just one day after), then this means that your investment will lose value again as well as falling in price due to market movements over time.
What is inverse gearing?
Inverse gearing is the opposite of leverage, and it’s a way to hedge your bets against a stock market crash or other market downturn. With inverse gearing, you borrow money to buy an asset and then sell it for a profit. The borrowed asset can be anything from stocks or bonds to commodities like gold or oil. The easiest way to understand inverse gearing is by thinking about how it works for leveraged ETFs: If you buy shares in an ETF on margin (borrowed money), then sell those same shares at a higher price than you paid for them—or if they decline in value—you earn money from your investment. In other words, the more the share price goes down, the more likely you are to make money on your investment because all of those losses will be offset by whatever profits come from selling them at their higher cost basis price before interest charges start kicking in.
What is the difference between a leveraged ETF and an inverse ETF?
Inverse ETFs are designed to move in the opposite direction of an index. For example, if an inverse S&P 500 ETF moves up 20%, it would indicate a 20% decline in the S&P 500 index.
Leveraged ETFs, on the other hand, are designed to move a multiple of an index’s daily performance. So if an S&P 500 leveraged ETF moves up 1%, it would indicate a 1% gain in the S&P 500 index. Because they track returns from futures contracts instead of actual stocks or bonds like traditional exchange-traded funds (ETFs), leveraged and inverse ETFs can be used to generate outsized returns with less risk than investing directly into stocks or other securities that make up an asset class.
What are some examples of leveraged ETFs?
You can find leveraged ETFs that track the performance of a broad range of indexes or individual stocks, including:
- Proshares Ultra VIX Short-Term Futures ETF (UVXY)
- Proshares Ultra VIX Mid-Term Futures ETF (UVXY)
- Proshares Ultra VIX Long-Term Futures ETF (UVXY)
Proshares Ultra VIX Short-Term Futures ETF (UVXY) is an example of an ETN that tracks the S&P VIX Short-Term Futures Index. This index includes futures on the CBOE Volatility Index, which measures the market’s expectation of stock market volatility over a one-month period. It also includes options on these futures contracts.
What are the advantages of investing in a leveraged ETF?
Leveraged ETFs are a great way to profit from short-term price movements. If you’re a trader, they’re a quick and easy way to turn small profits into larger ones using leverage.
If you’re a long-term investor, leveraged ETFs can help reduce volatility in your portfolio by magnifying gains when the market is going up (and losses during downturns). This is especially useful if your goal is to steadily grow an investment over time but want some protection against wild swings along the way.
What are the risks of investing in a leveraged ETF?
You need to be aware of the risks associated with leveraged ETFs.
The most obvious risk is that the underlying index could move in the opposite direction to that which you expect it will move. This means if you buy an ETF with a 1x leverage, and the underlying index goes up 2%, then your investment will lose value by 1%. In other words:
- If you buy an ETF with a 2x leverage and the underlying index goes up or down 1%, then your investment will double (or halve).
- If you buy an ETF with a 3x leverage and the underlying index goes up or down 1%, then your investment will triple (or reduce to one third).
It’s important to note that this is not just something that can happen immediately—the movement could be more gradual than expected over time. For example, if there was an event where stocks fell by 20% in one day but recovered 10% of that fall within three months, then investors who bought into these leveraged ETFs would have been left significantly worse off than those who simply invested in regular funds during these periods.
When it comes to leveraging, there’s no magic bullet. Leveraging works for some investors who have a good risk management plan in place, but it’s also risky.
- Leveraging is a double-edged sword. It can be used to make lots of money, but it can also cause you to lose all your money if you’re not careful.
- A leveraged ETF is a great tool for hedging or speculating.
- Leverage also works in reverse: if the market goes down, the leverage will magnify that loss and make it worse than it would have been otherwise (this is called “negative convexity”).
Leveraged ETFs are most useful for short-term trading. If you want to speculate on the market and make money in a short period of time, leveraged ETFs can be very profitable. But if you use them as long-term investments, they can be very dangerous.
Leveraged ETFs are a great way to leverage your investment and make more money on your investments. However, they are also very risky and you need to be careful with how much money you invest in these types of funds.
