A leveraged ETF is a specific type of exchange-traded fund (ETF) that’s designed to amplify investment returns. With traditional ETFs, which are mutual funds that trade on an exchange like a stock, the aim is typically to match the performance of a benchmark index. Leveraged ETFs, on the other hand, seek to multiply the returns of a specific stock market index or asset class. In other words, it’s an active, rather than passive, investing approach.
- How do leveraged ETFs work
- Which indexes do leveraged ETFs track?
- Pros and cons of leveraged ETFs
- How to use leveraged ETFs in your investing strategy
- Most popular leveraged ETFs
How do leveraged ETFs work
Traditional ETFs own shares of stock or other securities that represent all of the securities in the underlying indexes they track. So an ETF that tracks the S&P 500 Index, for example, would include shares of all of the companies in that index.
A leveraged ETF takes a different approach, relying on debt instruments and derivatives to boost investment returns based on the performance of an underlying index. A leveraged ETF can use any of the following investment strategies to achieve its goals:
2x and 3x leveraged ETFs
Leveraged ETFs typically use an amplification factor of two or three to magnify the gains of an underlying index. This means the ETF is buying two or three times the exposure to the index.
So a triple-leveraged ETF, or 3x leveraged ETF, would have a ratio of $1 of investors’ money for every $3 of debt. In theory, investing in a 3x ETF would then return a 3% gain for every 1% gain realized by the underlying index that the fund is attempting to outperform.
A 2x ETF, on the other hand, would use a leverage factor of two instead to double returns for investors. Remember, this is based on the returns of an underlying index within a specific trading window — typically one day — not the average annualized return of the index.
Inverse leveraged ETFs
Some leveraged ETFs can be inverse ETFs, meaning they attempt to amplify returns based on the opposite of how an index performs. So if you own a 3x ETF that’s inverse and the index it tracks sees returns drop by 3%, the ETF would return 9%. But if the index posts a positive return of 3%, then a 3x inverse leveraged ETF would drop by 9%. With an inverse leveraged ETF, the intent is to profit from declines in the index being tracked.
These funds can sometimes be referred to as bearish leveraged ETFs. The Direxion Daily S&P 500 Bear 3X Shares ETF, for example, offers 3x daily short leverage to the S&P 500 Index. This type of ETF might appeal to investors who have a bearish view of U.S. large-cap stocks in the short-term.
Which indexes do leveraged ETFs track?
Leveraged ETFs can be benchmarked against a number of stock market indexes. Some of the largest indexes that are often utilized for leveraged ETF trading include:
- The S&P 500
- The Dow Jones Industrial Average (DJIA)
- The Nasdaq 100
- The Russell 2000 Financial Services Index
- The NYSE Arca Gold Miners Index
- Dow Jones U.S. Oil & Gas Index
By tracking such a broad range of indexes, leveraged ETFs offer investors an opportunity to diversify investment gains beyond just stocks.
Some leveraged funds can also be sector- or asset class-specific. A leveraged gold ETF, for example, can deliver amplified daily or monthly returns on gold prices for investors who are looking to add precious metals exposure to their portfolios. A leveraged oil ETF seeks to do the same, only investors are swapping out oil prices for gold prices.
One important thing to note about leveraged ETFs and inverse leveraged ETFs is that they typically reset their exposure to the index they’re tracking daily. This means the objective of the ETF and its return multiplier can change each day. Some leveraged ETFs reset monthly but that’s less common.
Pros and cons of leveraged ETFs
Investing in leveraged ETFs can offer advantages and disadvantages. It’s important to weigh both sides to determine whether these investments are right for you.
Pros of investing in leveraged ETFs
- Increased exposure: Leveraged ETFs allow you to increase exposure to an underlying index without making an additional capital investment.
- Magnified upside: With leveraged ETFs, the upside is magnified so there’s a potential for much greater returns with this type of investment.
- Highly liquid: Leveraged ETFs can be highly liquid investments so your money isn’t locked in for the long-term.
- More accessible than other alternatives: These ETFs are more accessible to everyday investors compared to other stock alternatives.
Cons of investing in leveraged ETFs
- Higher risk: While you could reap significantly higher returns with a leveraged ETF or inverse leveraged ETF, you’re also multiplying the risk factor.
- Potential for tracking error: Tracking error occurs when a security’s price doesn’t follow the index it was meant to track, meaning you may not be able to bank on higher returns.
- Costly: While traditional ETFs can offer very low expense ratios, leveraged ETFs are typically a more expensive investment option. For example, a typical ETF may have an expense ratio below 0.50% but a leveraged ETF may have an expense ratio as high as 3%.
Aside from those considerations, it’s important to note that investing in leveraged ETFs requires you to be hands-on when it comes to choosing which ETFs to invest in and making trades. This is not an investment approach that’s designed for the passive investor who’s hoping to remain hands-off with their portfolio.
If you don’t have the time or the patience to thoroughly research leveraged ETF investments and stay active with trading, then you could be setting yourself up for losses rather than gains.
How to use leveraged ETFs in your investing strategy
If you feel confident that leveraged ETFs are right for you, understand first that they make the most sense as part of a short-term investing strategy. If you need long-term diversification and index exposure, then you’re likely going to be better off with a traditional index mutual fund or ETF.
Before buying your first leveraged ETF, take time to research funds. Specifically, you should:
- Determine which indexes or sectors you’re interested in gaining exposure to in your portfolio.
- Review the fund’s prospectus to understand its objectives and how it attempts to achieve them.
- Consider the fund’s historical performance trends, though do keep in mind that past performance is not an indicator of future returns.
- Compare the performance of the underlying benchmark or index the ETF tracks.
- Determine what percentage of your portfolio holdings you’re comfortable committing to leveraged ETFs.
- Consider the costs involved, in terms of management fees and commissions.
When in doubt, it may be best to start small with investing in leveraged ETFs. You can then expand your position as you become more familiar with how these ETFs operate.
You may want to talk to your financial advisor about where leveraged ETFs fit into your overall investment plan. Your advisor can offer perspective on what leveraged ETFs can (or can’t) help you do when it comes to satisfying your investment objectives.
Most popular leveraged ETFs
If you need some direction on which leveraged ETFs to invest in, consider this leveraged ETF list and 3x ETF list, both of which include some of the most popular choices for investors.
Top leveraged ETFs for 2020
- ProShares UltraPro Short QQQ (SQQQ)
- ProShares UltraPro Short S&P 500 (SPXU)
- ProShares UltraPro Short Dow30 (SDOW)
- ProShares UltraPro Short Russell2000 (SRTY)
- Direxion S&P 500 Bull 2x (SPUU)
- ProShares UltraPro Short MidCap400 (SMDD)
- ProShares UltraPro Short Financials (FINZ)
- ProShares UltraPro Short Nasdaq Biotechnology (ZBIO)
- iPath LX Russell 2000 TR Index ETN (RTLA)
Top 3x leveraged ETFs for 2020
- Direxion Daily S&P 500 Bear 3X Shares (SPXS)
- Direxion Daily Gold Miners Bull 3X Shares (NUGT)
- Direxion Daily Small Cap Bear 3X Shares (TZA)
- Direxion Daily Financial Bear 3X Shares (FAZ)
- VelocityShares 3x Inverse Natural Gas (DGAZ)
- Direxion Daily Real Estate Bear 3x Shares (DRV)
- Direxion Daily 20-Year Treasury Bear 3X (TMV)
- VelocityShares 3x Inverse Crude Oil ETN (DWT)
- United States 3x Oil Fund (USOU)