ETFs (Exchange Traded Funds) are popular in the US market.
And leveraged ETFs are less known by everyone. In India, we do not have to leverage ETFs, but these are available in the US market.
What is a leveraged ETF?
Leveraged ETFs are exchange-traded funds that use financial derivatives and debt to increase the returns of an underlying index like the S&P 500.
Leveraged ETF possesses high risk and return attributes. A leveraged ETF tries to boost the daily returns of the index. They basically take the margins/leverage by using debt and financial derivates.
How do leveraged ETFs work?
Traditional ETFs try to match the returns of the benchmark, but leveraged ETFs try to maximize the returns two to three times rather than just matching the benchmark’s performance.
Leverage ETFs use borrowed money to invest in financial derivatives such as future and option contracts.
For example, an ETF that tracks the S&P 500 index will try to replicate the returns of the benchmark.
But leveraged ETF will seek to maximize returns on a 2:1 or 3:1, expressed as 2x or 3x, respectively. Suppose an S&P 500 tracking ETF has generated returns of 2%, then a leverage ETF 2x can provide you 4% returns.
And if the S&P 500 tracking ETF has generated negative returns of 3%, then a leverage ETF 2x can provide you 6% negative returns.
Are leveraged ETFs expensive?
Usually, traditional ETFs have an expense ratio of around 0.45%, but leveraged ETFs have an expense ratio of around 1.00%.
The reason for the higher expense ratio is the frequent trading of underlying securities using leverage. A higher expense ratio reduces the returns of a leveraged ETF.
Pros and Cons of leveraged ETFs
Pros
- Easily to trade – Like any other ETFs, leverage ETFs are also traded on the exchange in the open market operations, just like stocks. So, it becomes easy to trade in leveraged ETFs.
- Access to derivatives – Leverage ETFs provide indirect access to financial derivatives, such as future and options contracts, which may not be accessible by everyone or cost high to trade.
- Potential to provide exceptional returns – Since these ETFs use leverage and invest in equity derivatives, they have the potential to provide exceptional returns to their investors compared to traditional ETFs.
Cons
- Higher expense ratio – Comparatively leveraged ETFs require more management; due to this reason, these ETFs have a higher expense ratio than traditional ETFs. So, these ETFs could cost you more as they are associated with trading in financial derivatives.
- High risk – Leverage ETFs have high market risk compared to normal ETFs. Suppose the market or underlying security is not moving in one direction. In that case, these ETFs can erode the value of your money over time as they might have taken the opposite position.
- Poor long-term holdings – Since these ETFs mainly trade in derivatives of underlying securities, so they do not hold any security for a longer period. They only use stocks for a short-term period to generate daily profits.
Conclusion
Leverage ETFs can provide you with hefty returns, but they can also erode your wealth if the market reacts inversely. Evaluating leveraged ETFs is very crucial before investing.
You can choose a normal ETF if your risk appetite is less, or a 2x/3x leveraged ETF if you take very high risk.
