Many investors like exchange-traded funds (ETFs) because they offer instant diversity and can be traded like stocks on the market. However, with ETFs, you’re not likely to do better than the performance of the underlying investments or index. For example, with an S&P 500 ETF, you’re not going to beat the market.
That changes, however, if you invest in a leveraged ETF. With these types of ETFs, you could end up seeing returns in excess of the underlying investments. So, with a leveraged S&P 500 ETF, your returns would double or triple the day's performance — or exceed the day’s losses.
Let’s take a closer look at what is a leveraged ETF, and how it works.
The Short Version
- Leveraged ETFs make use of borrowing, usually through options, to increase potential gains.
- The increased exposure tracks daily changes, so gains and losses occur on a daily basis.
- There are a number of different types of leveraged ETFs, including inversed leveraged, leverage tech, and leveraged bond ETFs, among others.
- Leveraged ETFs are better as short-term investments.
- They are more expensive and are riskier than other ETFs.
What Is a Leveraged ETF?
Any investment that uses leverage is one that makes use of borrowing to magnify gains. When you invest in a leveraged ETF, you’re essentially buying shares in an asset that offers returns above what the “regular” ETF would have offered. However, it’s important to understand that you could also see magnified losses. This makes leveraged ETFs a high-reward, high-risk proposition.
How Do Leveraged ETFs Work?
With leveraged ETFs, the manager of the fund uses investments like options to increase the exposure to what’s in the index. A leveraged S&P 500 ETF, for example, might make use of options contracts to magnify the performance of the ETF as a whole, focusing on the assets listed on the S&P 500 index.
This increased exposure tracks daily changes, not annual returns, so the gains or losses can mount on a daily basis. It’s also important to note that there are inverse ETFs that magnify the opposite of an ETFs performance.
What Is a Triple-leveraged ETF?
With a triple-leveraged ETF, you end up with three times the performance. So, if your leveraged S&P 500 ETF gained 1% that day, your gains would be 3%. With an inverse ETF, if the underlying investments were to lose ground, you’d see gains.
It’s important to note, though, that your losses are magnified as well as your gains. If the ETF loses 1% on the day, your own losses would be 3%.
What Is a 10x Leveraged ETF?
As you might expect, a 10x leveraged ETF is one that would theoretically magnify gains (and losses) of the underlying investments by a factor of 10. However, finding these types of ETFs is practically impossible for most retail traders. In most cases, leveraged ETFs are either 2x or 3x.
Best Leveraged ETF Types
There are a number of different types of leveraged ETFs. Choosing the best one for you depends on your risk tolerance and financial goals. Some of the types you’ll find include:
- Leveraged S&P 500 ETF: These track the S&P 500 on a daily basis and magnify the gains or losses. These offer a wide range of diversity.
- Inverse leveraged ETF: You can receive gains (or losses) based on the opposite of how an ETF performs. If you think an specific index or basket of investments will fall, you can invest in an inverse leveraged ETF to benefit from market drops.
- Leveraged tech ETF: These types of ETFs focus specifically on companies in the tech sector.
- Leveraged commodity ETF: You can find leveraged ETFs that focus on baskets of commodities, including oil, farm products and precious metals.
- Leveraged bond ETF: Rather than tracking commodities or stocks, these ETFs track the daily performance of bond investments and indexes.
- Leveraged gold ETF: These include tracking for baskets of gold miners and producers and others in the supply chain.
- Leveraged silver ETF: Tracks different investments related to the mining, processing and sale of silver.
- Leveraged oil ETF: Can track different types of oil, as well as track stocks related to the production and transportation of oil
- Leveraged natural gas ETF: Looks at the natural gas process and supply chain and invests in assets related to it.
Carefully think about what is likely to work best in your portfolio and complement your current investments, as well as what could potentially help you reach long and short-term goals.
Leveraged ETFs as Short-term Investments
If you decide to invest in leveraged ETFs, it’s important to note that these are generally considered short-term investments. Because leveraged ETFs track daily changes to underlying assets, it’s important to understand when to enter and exit your position.
Leveraged ETFs are also highly volatile because they operate based on daily market fluctuations. As a result, they aren’t usually suitable for buy and hold investments. It’s vital that you consider this in your investing strategy.
The Cost of Leveraged ETFs
Because leveraged ETFs make use of various derivatives in an effort to magnify gains, they usually come with higher costs. For example, options contracts usually come with premiums. These premiums are figured into the cost of the ETF, and passed onto you. It’s common to see expense ratios of at least 1% when you’re trading leveraged ETFs.
Other costs are important to understand as well. If you use margin to invest in more shares, you’ll pay those costs. Usually, margin comes with an APR that you have to cover and that reduces your overall returns.
Finally, there’s a cost when your ETF doesn’t perform as well as you expect. While many people like the idea of magnifying gains with ETFs, the reality is that losses are magnified as well. If the ETF doesn’t perform the way you expect, or if you don’t exit your position before the ETF heads downward, you could end up with bigger losses — and that’s a cost that can be further amplified if you trade on margin.
Also, remember the bigger your leverage, the bigger your potential losses. A triple-leveraged ETF will come with larger risks and potential losses than a double-leveraged ETF.
Pros and Cons of Leveraged ETFs
Short-term Investments with High-risk and High-reward
Leveraged ETFs offer you the opportunity to invest in assets that could potentially provide you with gains above and beyond what you would normally see from underlying assets. However, these are short-term investments that focus on daily performance and magnifying that performance.
In addition to the potential for high rewards, you also have a higher level of risk. Losses are magnified as well as gains, so you need to make sure that you only invest money you can afford to lose when you buy leveraged ETFs.