What are Leveraged ETFs? Leveraged ETFs Explained

Who does not dream of getting higher returns from the equity, or an investment getting doubled?

Precisely because stock markets are always rising in the long term, this seems to be a good business. A business that seems to be within reach. Thanks to the leveraged ETFs.

However, it’s true, which is why we took a deeper look into the subject for you.

What is a Leveraged ETF?

A Leveraged Exchange-Traded Fund (or Leveraged ETF) uses financial results and credit to leverage the returns of an underlying index.

Leveraged ETFs are mostly available only for indexes, like the NASDAQ 100 and the Dow Jones Industrial Average.

The aim of this funds is to constantly maintain the amount of leverage during a particular investment time frame.

For example, 2x or 3x Leveraged ETF.

The yield of an ETF can be elevated by a factor of two i.e., 2x leveraged ETF. So, if an underlying index rises 10 per cent, the leveraged ETF rises 20 per cent.

However, this also applies vice versa. This means that if an underlying index falls by 10%, the 2x leveraged ETF falls by 20%.

Leveraged ETFs typically track the daily performance of an index, and that's where it gets really interesting.

In the financial jargon one often says: The positions are closed daily.

The effects of this approach are significant. In the example given, assuming a starting value of 100%, the whole thing looks like this:

Day 1

Scenario A: 120 (+10 per cent on Day 1)

or

Scenario B: 80 (-10 per cent on Day 1)

Day 2

Scenario A: The index drops back to 100, which equals -9.09%.

Scenario B: The index rises back to 100, which equals + 11.11%.

Intuitively one might think that the leveraged ETF is back to 100 in both cases. But that is not so. Let's take a look at the mathematics behind it:

The leveraged ETF is then included after Day 2

Scenario A at 98.18 (-18.18 per cent on day 2)

Scenario B at 97.78 (+22.22 per cent on Day 2)

All in all, the bottom line of the ETF is losing value. This is because the leveraged ETF somehow creates a kind of negative compounding effect.

Scenario C: Initial value also 100 and leverage factor x2. Two days in a row with a value increase of 10%

Stand density index after 2 days: 121

Both Leveraged ETF after 2 days: 144

The leveraged ETF has thus outperformed the underlying index by a factor of 2.095. That's why a leveraged ETF is a very alluring thing when the stock price ruler goes up. Now, however, this is very rare on the stock market. Although the value of the market usually rises over a longer period of time. There are daily fluctuations and a consistently positive performance does not exist in practice.

Since the position is closed daily, it is much more likely that one will suffer from the "negative compounding effect". As a rule of thumb, the greater the volatility, the greater the "negative compounding effect".

In technical jargon, one speaks of a so-called path dependence. The performance of the leveraged ETF thus depends on which path the index takes.

With the short ETFs, or inverse ETFs, you can bet on falling prices, but these too are subject to path dependency.

Therefore, the risk in leveraged ETF is high, and one should be careful with it. One should have a clear idea of ​​whom the leveraged ETF is designed for.

Types of Leveraged ETFs

The first leveraged ETFs was launched by ProShares in 2006. In years since then, the number of leveraged ETFs available in the market has grown to over 200. ProShares and Direxion are the major suppliers.

ProShares' Russell 2000 ETF also competes directly with the Direxion's Daily Small Cap Bull 3x Leveraged ETF.

Shares (TNA) and Daily Small Cap Bear 3x Shares (TZA).

Both bullish and bearish fund exposures are provided to the different sectors, market, securities and currencies by the ETF providers. Various levels of exposure, like 125%, 200% and 300% of a given benchmark's daily performance.

For example, the Russell 1000 Financial Services Index is tracked by the Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS). Some of the top holdings include Berkshire Hathaway, JPMorgan Chase, and Wells Fargo.

Another example: The ProShares UltraPro Short S&P 500 ETF (NYSEMKT: SPXU). It is a triple-leveraged inverse ETF (3x Leveraged ProShares UltraPro Short S&P 500 ETF). It aims to return three times the inverse of the S&P 500's daily performance. In other words, if the S&P 500 Index falls by 10% today, this fund should theoretically gain 30%.

The fund seeks to produce 300% of the index's daily performance using various instruments.

For whom leveraged ETFs are suitable?

Leveraged ETFs and Short ETFs certainly are not designed for retail investors. Because retail investors usually pursue a long-term buy-and-hold strategy. Nevertheless, it is irresponsible that some banks do not shy away from selling risky leveraged ETFs. Some of which are best suited for very short-term investments, to unsuspecting private investors.

The clear target groups for leveraged ETFs are day traders and institutional investors. Both can use it cleverly to profit from short-term market expectations or hedge their portfolios.

For day traders, the best advantage is that they don’t have to raise the capital in order to leverage the ETF. Because that is something the respective fund company takes care of.

Investors can do that without such complex financial instruments as Futures, Options and Certificates.

You can find more about short selling at this link: https://en.samt.ag/short-selling.

In addition, it must not be concealed that the administrative costs are much higher, for example, with direct futures. These leveraged Exchange Traded Funds (ETFs) are not eligible for an ETF Savings Plan or to replace an Investment Fund. The expense ratios or costs are simply too high to use these funds for a long-term investment.

In addition, it must not be concealed that the administrative costs are much higher, for example, with direct futures. These leveraged Exchange Traded Funds (ETFs) are not eligible for an ETF Savings Plan or to replace an Investment Fund. The expense ratios or costs are simply too high to use these funds for a long-term investment.

In short term, however, these ETFs are suitable for buying and selling for daily returns or profits. With futures or options, the same strategies can usually be implemented at a lower price as that of leveraged ETFs.

This theme excellently demonstrates the importance of truly understanding the different asset classes first before you invest in them.

Conclusion: If you are not a day trader or an institutional investor, you should keep your hands off the leveraged ETF. To prepare for good annual returns you should bet on stocks or classic ETFs.