A way of enhancing returns whether you are investing in single stocks or indices is by using leverage. Until recently, it was not easily possible to access leverage without access to a margin account with a broker.
However, over the past years, instruments have been developed by the financial industry which carry embedded leverage in the security: enter leveraged ETFs. We look at what these products are, how people use them and what the risks associated with these return-(and risk)-enhancing securities are.
A way of enhancing returns whether you are investing in single stocks or indices is by using leverage. Until recently, it was not easily possible to access leverage without access to a margin account with a broker.
However, over the past years, instruments have been developed by the financial industry which carry embedded leverage in the security: enter leveraged ETFs. We look at what these products are, how people use them and what the risks associated with these return-(and risk)-enhancing securities are.
What are leveraged ETFs?
Quite simply — leveraged ETFs are exchange-traded funds with embedded leverage. It means their daily return is enhanced or multiplied by the leverage factor they carry. Most typically, the leverage is twice or three times the daily return of the underlying security or index.
For example, looking at the ProShares UltraPro QQQ (TQQQ), which seeks to replicate three times the daily performance of the NASDAQ-100 Index, this ETF is a triple-leveraged ETF based on the NASDAQ-100 Index.
It means that if the NASDAQ-100 Index increases by 1% in a single day, the return of the ETF holder would equal 3%. However, it also means, were the Index to drop in a single day by more than 33%, the entire capital of the holder of the ETF would be wiped out.
This clearly illustrates the advantage and dangers of leveraged ETFs: the potential to increase returns but also the high risk of losing all the capital should a high-impact event occur.
Advantages of leveraged ETFs:
- Leveraged ETFs amplify the daily returns of a benchmark index or stock using borrowed capital embedded in the ETF.
- Potential gains from these funds are multiplied, but potential losses are as well – making them both lucrative and very risky.
Types of leveraged ETFs
There are more than 170 levered exchange-traded funds listed on US stock exchanges With different types of leveraged ETFs available, from single-stock to equity and inverse, let's take a deeper dive into their features, advantages and potential risks.
1. Leveraged Index ETFs:
As outlined in the above example with the ProShares UltraPro QQQ ETF, these ETFs are based on a stock index or an index of a different type such as a Bond-Index, Treasury-Index or even a volatility Index. They are the most common type of leveraged ETF. Some products in Europe, called ETP (standing for ‘exchange-traded-product) even offer leverage up to 5x — for example the Leverage Share Long SPY ETP listed on the London Stock Exchange.
2. Single-Stock Leveraged ETFs
Similar to leveraged Index ETFs, the performance of single-stock Leveraged ETFs is based on the development of an underlying stock. They exist with different types of leverage ranging from 1x (or -1x) meaning no leverage up to 3x (triple-leveraged) but rarely above because single stocks tend to fluctuate more pronounced than Indices.
3. Inverse Leveraged ETFs:
Inverse Leveraged ETFs, as their name implies, move in the opposite direction as the benchmark index, allowing investors to benefit when the index falls. For example, a 2x inverse leveraged ETF will theoretically produce a 2% price increase if the benchmark index drops by 1 per cent in a day.
Risks and disadvantages of leveraged ETFs
A number of risks exist when employing leverage and we want to outline this for you in case you are contemplating adding leveraged ETFs to your holdings.
Speculative market risk
There is a heightened degree of market risk associated with levered ETFs. Seeking to multiply the daily returns of a benchmark index, meaning both profits and losses are amplified. In the event the market does not provide steady direction, leveraged ETFs often miss out on potential gains.
Not the best choice for long-term Investments
Exchange trades funds with leverage are engineered to hypothetically increase the daily returns of a benchmark index, so they are not ideal for longer investments. Over time, these ETFs may not match the performance of the index and tend to decline in value.
High fees
ETFs employing leverage have higher expenses than traditional ETFs, due to the need to trade financial derivatives. The average expense ratio for these ETFs is usually much higher than for traditional ETFs. These charges decrease the net return to the investor.
Compounding and Volatility Exposure
Compounding can be a double-edged sword, with the potential to generate great profits or significant losses in leveraged ETFs. This cumulative effect of profit and losses based on an initial capital stake over time can lead to substantial losses for 3x ETFs in times of market instability.
Catastrophic Losses
Triple-leveraged (3x) ETFs maintain the same leverage level, with the possibility of total collapse if the underlying index experience a 33% drop in a single day. Even without extreme market conditions, the high fees associated with 3x ETFs could still cause damage to the investor's portfolio long-term.
To sum up
Leveraged ETFs can provide a good option for active traders who would like to employ leverage in short-term trading strategies, especially in case they don’t have access to a margin account with a broker.
Due to the wide availability across stock markets, bonds, commodities and derivative indices such as volatility, they allow trading a range of markets with taking on additional risk embedded directly in the ETF.
However, the dangers of these products should not be underestimated — especially for passive and long-term investors, it is not a good idea to add such products to their portfolio, because of the compounding of volatility and high likelihood of extreme losses - a great example of the pros and cons of ETF investment.
If you enjoyed this article on leveraged risks then you should check out our piece on the risk opportunities associated with thematic ETFs.
