What are leveraged ETFs? All you need to know

You have seen several different types of ETFs. There are some specialized ETFs that use complex strategies to deliver a return. Leveraged ETFs are one such type of specialized ETF. 

What do leveraged ETFs mean?

• In layman’s terms, it means exerting force.
• In ETF parlance, it means generating a multiple of returns given some return of the underlying index.  

For instance, ProShares Ultra S&P 500 ETF is a leveraged ETF that returns twice the daily return of the S&P 500.

If the S&P is up 2% daily, the ETF will be up 4% after adjusting the expense ratio. Conversely, if the S&P is down 1.5%, the ETF will be down 3%. 

These leveraged ETFs rebalance their portfolio allocations daily. Thus, each day is considered a new day without any connection to the previous day.  

Most investors confuse this leverage with more time-bound influence, as in if the S&P is up 10% in a year, the ETF will be up 20% if it’s a 2x return ETF, which is entirely wrong!

These ETFs work on a daily leverage basis, and in the long run, the fund will not exactly replicate the underlying index.

The rebalancing of funds is done on a daily basis to generate an assured return. Continuing with our previous example, if the ProShares ETF is giving a 2x return, the ETF will have to acquire assets that are twice the value of the NAV of the fund.  

As an illustration, if a fund has 100 units of securities, the fund will swap these with the counterparty for exposure to 200 units of the performing assets. This rebalancing is usually in the direction of the market. 

Such leveraged ETFs can be shortly leveraged or long leveraged

• Long-leveraged ETFs will trace the market trend in the same direction.
• Short-leveraged ETFs will move on the contrary.  

For example, the ProShares UltraShort S&P 500 ETF design is such that if the S&P rises 5% in a day, the ETF goes down 10%, i.e., a 2x return in opposite direction. Similarly, if the index value falls 5%, the ETF will be up 10%. 

Since the rebalancing is on a daily basis, compounded growth, in the long run, doesn’t resemble the development of the underlying index.

Volatility in the market can severely dent the prospective gains of the ETFs, leading to severe underperformance compared to the underlying assets.

For instance, if a triple-leveraged ETF loses 30%, the underlying index must have lost only 10%.  

A leveraged ETF can lose its value in some tremendously sporadic cases, mainly when derivatives are part of the ETFs kitty. 

Let’s take some easy examples and understand how things pan out. 

1. Let’s take a scenario where the market is up 5% daily, and a 2x long leveraged ETF is traded.

Days	Daily market performance	Expected index level	Expected 2x leveraged long ETF level	Daily ETF performance
0	0%	100	100
1	5%	105.00	110.00	10%
2	5%	110.25	121.00	10%
3	5%	115.76	133.10	10%
4	5%	121.55	146.41	10%
5	5%	127.63	161.05	10%
6	5%	134.01	177.16	10%
7	5%	140.71	194.87	10%
8	5%	147.75	214.36	10%
9	5%	155.13	235.79	10%
10	5%	162.89	259.37	10%
10-day cumulative change		62.89	159.37

2. Let’s take a scenario where the market is down 5% daily, and a 2x long leveraged ETF is traded:

Days	Daily market performance	Expected index level	Expected 2x leveraged long ETF level	Daily ETF performance
0	0%	100	100
1	-5%	95.00	90.00	-10%
2	-5%	90.25	81.00	-10%
3	-5%	85.74	72.90	-10%
4	-5%	81.45	65.61	-10%
5	-5%	77.38	59.05	-10%
6	-5%	73.51	53.14	-10%
7	-5%	69.83	47.83	-10%
8	-5%	66.34	43.05	-10%
9	-5%	63.02	38.74	-10%
10	-5%	59.87	34.87	-10%
10-day cumulative change		-40.13	-65.13

3. Let’s take a scenario where the market is down 5% and up 5%, and a 2x long leveraged ETF is traded.

Days	Daily market performance	Expected index level	Expected 2x leveraged long ETF level	Daily ETF performance
0	0%	100	100
1	5%	105.00	110.00	10%
2	-5%	99.75	99.00	-10%
3	5%	104.74	108.90	10%
4	-5%	99.50	98.01	-10%
5	5%	104.48	107.81	10%
6	-5%	99.25	97.03	-10%
7	5%	104.21	106.73	10%
8	-5%	99.00	96.06	-10%
9	5%	103.95	105.67	10%
10	-5%	98.76	95.10	-10%
10-day cumulative change		-1.24	-4.90

These are the types of results you can expect if you hold a leveraged ETF.

So, an investor must not get deceived by the vocabulary of the ETF, i.e., 2x isn’t the 2x that you think. Traders for making quick short-term gains have used leveraged ETFs. 

Suppose an investor predicts that the price of natural gas will increase in the coming days or weeks, then investing in a leveraged ETF to enhance the return is sensible if the prediction is correct.

However, if it’s the other way around, he can buy some inverse leveraged ETFs to maximize his gains and thus act as a hedge to prevent potential losses. 

If the prediction is wrong, the losses are magnified by such ETFs. 

How do Leveraged ETFs Work? 

Let’s say an investor buys shares of a 3 times-leveraged ETF for $200. If the underlying index rises 20% in a single session, the investor gains 60%, boosting the investment to $320. 

Leveraged ETF resets every day for the next session. If the underlying index drops 10% the following day, the position’s value declines 30% to $272. 

As and when the stocks and market indexes fall or rise over time, longer-term positions in leveraged ETFs can become very challenging to hold, thanks to amplified gains and losses. 

Who should invest in Leveraged ETFs?

Leveraged ETFs are best for seasoned investors with a comprehensive understanding of the risks involved and how it works. 

Leveraged ETFs offer an opportunity to add significant value to a trader’s overall investment strategy who has an appetite for risk, significant experience, and wish to amplify daily returns in both uptrend and downtrend. 

When volatility in the market increases, leveraged ETFs can be effectively used for hedging purposes. Leveraged ETFs can open up many new opportunities if the objective is to hedge your trades and enhanced returns. 

Remember to research leveraged funds with caution, as losses can be magnified similarly to returns. 

Proceeding with caution and doing due diligence before acting is the way to go.

Consult our expert advisor to get the right plan for you