September 5th, 2017

Leveraged ETFs – The Pros and Cons

Many ETFs help build wealth, but some are higher-risk strategies 

Before investors and advisors consider making use of leveraged exchange-traded funds (ETFs), its important to understand how these products function and whether they belong in an investor’s portfolio.

What are they?

Leveraged ETFs are complex securities that mimic or track indices, commodities or currencies, but use an innovative structure that aims to enhance returns.

Leveraged ETFs are short-term oriented

Leveraged ETFs seek to provide daily performance, before fees and expenses, equal to a multiple of the daily performance of the benchmark index. To meet this objective, leveraged ETFs use forward contracts, which are customized agreements between brokers and dealers to buy and sell assets at a specified price at a certain future date.

The key word is daily. A leveraged ETF should not be expected to deliver the stated multiple of the index return over a longer investment horizon beyond one trading day.

For example, a 2x leveraged ETF seeks to provide 200% of the daily performance of the benchmark index. Suppose the index return on a given day is 1%. A 2x leveraged ETF would be expected to deliver a return of 2%, before fees and expenses, on the same day. If the index return for a given week is 4%, a 2x leveraged ETF should not be expected to deliver a return of 8%, before fees and expenses, for the same week.

“Path dependency” means that, over longer time frames, returns rely on the direction of the underlying benchmark. If there are many up-and-down days over the period, returns could be lower than expected due to the magnification of the multiples on any given day. In other words, how the market moves has a greater impact than where the market ends up.

Mind the gap

Over a time period of longer than one day, the gap between the return of a 2x leveraged ETF and a twice-the-index return depends on:

  • The volatility of the index return, as higher volatility will widen the gap
  • The length of the holding period, as the gap will widen as the holding period becomes longer
  • The absolute value of the returns, as a higher absolute value will widen the gap

The significance of using leverage is that it magnifies gains and losses. You typically want to use leverage if you expect the investment to go up. If you are correct, leverage will magnify your gain. However, if you are wrong, leverage will magnify your loss. You can even lose more than the amount of your original investment. When an ETF uses leverage, this increases the risk. The higher the leverage, the greater the risk.

Leveraged ETFs may be suitable for investors with a high risk tolerance, whose investment horizon is one day – to capture expected returns for that day – and who are prepared to monitor and adjust their portfolios daily. They are not designed for buy-and-hold investors with long-term investment time horizons.

Advisors who are interested in these ETFs for their clients should check with their dealer to see if they are eligible to buy and sell them. For more information, check out the IFSE course on ETFs.