ETFs are a great way to generate returns from passively following an index. But what is a leveraged ETF, and can it give the dual benefit of passive investing with high returns? Let us find out.
An exchange-traded fund pools investor money to trade in a basket of stocks that resemble an underlying index, commodity, sector, or simply a trading strategy.
Effectively, ETFs operate very much like mutual funds, but the key difference is that they are bought and sold on the markets and can be traded at any time.
Mutual fund NAVs only change once a day, and all transactions happen at that price.
Moreover, these financial instruments have a lower average expense ratio and are typically much more tax efficient than corresponding mutual funds.
Leveraged ETFs use the same philosophy of tracking a particular index, but they try to amplify the gains made from traditional index tracking.
What Is a Leveraged ETF?
Leveraged Exchange Traded Funds use debt and financial derivatives to magnify the returns from the market index that they are following.
In other words, if the index returns are 1%, a Leveraged ETF tries to give a 2% or 3% return.
If it is aiming for a 2% return, it is called a double-leveraged ETF, and for a 3% return, traders call it a triple-leveraged ETF.
However, the thing to note is that the returns work both ways — if the index goes down, the loss is also magnified by this financial instrument.
Most highly traded indexes such as the Nasdaq 100 or the Dow Jones Industrial Average have Leveraged ETFs available in the market.
Another similar concept is inverse leveraged ETFs, which profit from tracking a declining benchmark rather than a gaining one.
How Exactly Do Leveraged ETFs Work?
Leveraged ETFs use borrowed money to invest in derivatives and options on the index instead of directly investing in the underlying stocks. This helps amplify the returns.
Traditional ETFs simply match the index in a 1:1 ratio in terms of returns.
They don’t need to borrow money because they are simply maintaining a portfolio of the same stocks as the index. As the index moves, the net asset value of the ETF moves as well.
Leveraged ETFs are greedier — they want to track the index but aren’t happy with just 1:1 returns. They use derivates of the underlying benchmark to generate better returns.
One common derivative they use is options. Let us explain how using options can amplify returns.
An option, as the name suggests, is just the right (and sometimes the obligation) to buy or sell a stock at a later date at a pre-agreed price.
Since the option is not a physical stock, merely a right to the stock sometime in the future, it sells for considerably lower than what the security sells for in the market.
Hence for a much lower investment, you are getting the same benefit, thus amplifying the overall returns from the trade.
There are two points to note here…
Firstly, investors should know that returns amplify both ways; if the gains are higher, so are the losses.
Secondly, leveraged ETFs try to match returns for the day, unlike normal ETFs, which match returns over long periods. They reset their price every day so that they can track the index.
Do Leveraged ETFs Pay Dividends?
Yes. leveraged ETFs also pay out dividends. However, the dividends are not correlated to the securities in the underlying index the way they are with normal ETFs.
They do not buy the stocks of the index. Instead, they trade in derivatives of the index. This lets them track the benchmark but still leaves them with extra cash.
They invest this remaining cash in various ways. One part of the dividends paid out is the returns raised from this activity.
Similarly, any capital gains from the derivatives trade are also shared with investors as dividends.
On the other hand, traditional ETFs use the gains made on trading to pay out dividends.
Can You Hold Leveraged ETF Long Term?
Yes, investors can hold leveraged ETFs long-term. However, it might not be in their best interest to do so. The value of their investment is more likely to fall the longer they hold it.
Leveraged ETFs use derivatives to multiply the returns made on the benchmark index. These derivatives take advantage of short-term bets for better returns.
In the long term, the losses from this strategy tend to compound more than the gains, which makes it a bad long-term investment.
This asset class is best used by short-term traders for amplifying daily returns.
What Is Wrong With Leveraged ETFs?
Market volatility ends up multiplying the losses much more than the gains of any underlying asset. Hence, the longer the investor holds on, the likelier they are to lose money.
Let us understand this with an example.
Suppose we have a regular ETF tracking the S&P 500 Index (ETF A) and a triple-leveraged ETF tracking the same S&P 500 (ETF B).
Assume that both ETF A and ETF B start out with a NAV of $100 for the sake of simpler calculations.
On day 1, let us say that the S&P 500 falls by 10% of its value.
Then ETF A would fall by about 10%, and ETF B would fall by about 30% (Since it is tracking the gains and losses three times the original amount).
This means ETF A falls to $90 and ETF B falls to $70.
Now, one might think that the greater fall in the triple leveraged ETFs would, later on, get compensated because it will rise more when the markets go up.
However, what investors must understand is that ETF B would require the S&P 500 to rise much higher to recover the same losses.
Let’s put this in numbers.
Suppose the S&P 500 gains 11.11% the next day. This would take it back to its original value.
ETF A, which is tracking the index 1:1, would also go up by 11.11% and recover back to its original position ($100).
ETF B, however, will grow 3 x 11.11% = 33.33%. This would take it from 70 to $93.33, not the original $100.
Thus, even if the S&P 500 comes back to its original position, ETF B would still be lagging. This impact keeps compounding over time, making ETF B a bad option for the long term.
In the short term, however, leveraged ETFs can help you multiply your gains from tracking an index.
Can ETF Go Bust?
Yes, ETFs can go bust. This usually happens when an ETF cannot generate enough interest among investors to continue.
Leveraged ETFs might go bust if their entire value gets eroded in a major fall of the underlying asset they are tracking.
If an ETF goes bust, there are generally two options for investors. They might either sell the units that they are holding or wait for the liquidation of the fund.
During liquidation, the ETF managers will sell all the holdings, pay back any obligations and then divide the remaining amount among the shareholders left.
This amount might even be lower than the last traded price of the ETF.
Can You Lose More Than You Invest with a Leverage ETF?
No, at best, you can lose all the money that you invested, but not more than that. Other forms of traditional leveraged instruments might end up with a bigger loss than the investment.
With a leveraged ETF, the value can never fall below zero, so you can always sell it and not lose more than what you invested.
In margin trading, which is another form of leveraged trading, it is possible to lose more.
Let’s understand how.
Margin trading involves trading through borrowing. Suppose an investor wants to buy a stock worth $100 and hopes to see it grow to $150.
If they buy the stock in cash, the entire $100 goes from their own pockets. If the stock goes up to 150, they make a 50% profit.
However, another way to do this is to spend $50 in cash and $50 in margin money, which is nothing but borrowed money from a broker.
If the stock now reaches $150, the investor makes a 200% return on the initial $50 invested. They also owe back $50 and some interest to the broker.
Assuming that the interest amounts to $10, the investor is still left with $40 from the trade on an initial investment of just $50. This is an 80% return.
However, if the stock ends up going down to $50 instead, the trader loses all their money and still owes $50 + $10 to the broker.
The total loss becomes $60, which is higher than the amount they invested.
Are Leveraged ETFs a Good Investment?
Leveraged ETFs can amplify returns over the short term. However, they are not a good way to invest for the longer term.
In the short term (such as an intraday trade), a leveraged ETF might be able to take advantage of a rising index and double or even triple that return to the investor.
However, as we showed earlier, leveraged ETFs need the index to recover far more than traditional ETFs to recover losses in the long term.
This is why for long-term investing, leveraged ETFs are not a great option.
Leveraged ETFs are a riskier asset class than traditional ETFs. They try to amplify the returns from investing in an underlying index but also end up amplifying the losses.
Moreover, it is harder for a leveraged ETF to return back to its original price after a fall in the index as compared to a traditional one.
Therefore, this asset class is not a good fit for long-term investing. However, for short periods such as intraday trading, leveraged ETFs can enhance returns.