Leveraged exchange-traded funds are a relatively new and unfamiliar product to most investors, but they could be the ticket investors need to bring in increased returns.

These funds are designed to deliver a greater return than through holding regular long or short positions. In this article we explain what leveraged ETFs are and how they work in both good and bad market conditions.

SEE: Leveraged ETFs: Are They Right For You?

About Leveraged ETFs
Exchange-traded funds (ETFs) are traded on a stock exchange. They allow individual investors to benefit from economies of scale by spreading administration and transaction costs over a large number of investors.

Leveraged funds have been available since at least the early 1990s. The first leveraged ETFs were introduced in the summer of 2006, after being reviewed for almost three years by the Securities And Exchange Commission (SEC). Leveraged ETFs mirror an index fund, but they use borrowed capital in addition to investor equity to provide a higher level of investment exposure. Typically, a leveraged ETF will maintain a $2 exposure to the index for every $1 of investor capital. The fund's goal is to have future appreciation of the investments made with the borrowed capital to exceed the cost of the capital itself.

Maintaining Asset Value
The first investment funds that were listed on stock exchanges were called closed-end funds. Their problem was that pricing of the fund's shares was set by supply and demand, and would often deviate from the value of the assets in the fund, or net asset value (NAV). This unpredictable pricing confused and deterred many would-be investors.

SEE: Open Your Eyes To Closed-End Funds

ETFs solved this problem by allowing management to create and redeem shares as needed. This made the fund open-ended rather than closed-ended, and created an arbitrage opportunity for management that helps keep share prices in line with the underlying NAV. Because of this, even ETFs with very limited trading volume have share prices that are almost identical to their NAVs.

Note: ETFs are almost always fully invested; the constant creation and redemption of shares does have the potential to increase transaction costs because the fund must resize its investment portfolio. These transaction costs are borne by all investors in the fund.

Index Exposure
Leveraged ETFs respond to share creation and redemption by increasing or reducing their exposure to the underlying index using derivatives. The derivatives most commonly used are index futures, equity swaps and index options.

The typical holdings of a leveraged index fund would be a large amount of cash invested in short-term securities, and a smaller but highly volatile portfolio of derivatives. The cash is used to meet any financial obligations that arise from losses on the derivatives.

There are also inverse-leveraged ETFs that sell the same derivatives short. These funds profit when the index declines and take losses when the index rises.

Daily Rebalancing
Maintaining a constant leverage ratio, typically two-times the amount, is complex. Fluctuations in the price of the underlying index change the value of the fund's assets, and this requires the fund to change the total amount of index exposure.

Example - Rebalancing a Leveraged ETF

Suppose a fund has $100 million of assets and $200 million of index exposure. The index rises 1% in the first day of trading, giving the firm $2 million in profits. (Assume no expenses in this example.) The fund now has $102 million of assets and must increase (in this case, double) its index exposure to $204 million. Maintaining a constant leverage ratio allows the fund to immediately reinvest trading gains.
This constant adjustment, also known as rebalancing, is how the fund is able to provide double the exposure to the index at any point in time, even if the index has gained 50% or lost 50% recently. Without rebalancing, the fund\'s leverage ratio would change every day and the fund\'s returns, as compared to the underlying index, would be unpredictable.

In declining markets, however, rebalancing can be problematic. Reducing the index exposure allows the fund to survive a downturn and limits future losses, but also locks in trading losses and leaves the fund with a smaller asset base.

Example - Rebalancing in Declining Markets
Consider a week in which the index loses 1% every day for four days in a row, and then gains +4.1% on the fifth day, which allows it to recover all of its losses. How would a two-times leveraged ETF based on this index perform during this same period?
Day Index Open Index Close Index Return ETF Open ETF Close ETF Return
Monday 100.00 99.00 -1.00% 100.00 98.00 -2.00%
Tuesday 99.00 98.01 -1.00% 98.00 96.04 -2.00%
Wednesday 98.01 97.03 -1.00% 96.04 94.12 -2.00%
Thursday 97.03 96.06 -1.00% 94.12 92.24 -2.00%
Friday 96.06 100.00 +4.10% 92.24 99.80 +8.20%

By the end of the week, our index had returned to its starting point, but our leveraged ETF was still down slightly (0.2%). This is not a rounding error. It is a result of the proportionally smaller asset base in the leveraged fund, which requires a larger return, 8.42% in fact, to return to its original level.

This effect is small in this example, but can become significant over longer periods of time in very volatile markets. The larger the percentage drops are, the larger the differences will be.

Note: Simulating daily rebalancing is mathematically simple. All that needs to be done is to double the daily index return. What is considerably more complex is estimating the impact of fees on the daily returns of the portfolio, which we'll cover in the next section.

Performance and Fees
Suppose an investor analyzes monthly S&P 500 stock returns for the past three years and finds that the average monthly return is 0.9%, and the standard deviation of those returns is 2%.

Assuming that future returns conform to recent historical averages, the two-times leveraged ETF based upon this index will be expected to return twice the expected return with twice the expected volatility, (i.e., 1.8% monthly return with a 4% standard deviation). Most of this gain would come in the form of capital gains rather than dividends.

However, this 1.8% return is before fund expenses. Leveraged ETFs incur expenses in three categories: management, interest and transactions.

The management expense is the fee levied by the fund's management company. This fee is detailed in the prospectus and can be as much as 1% of the fund's assets every year. These fees cover both marketing and fund administration costs. Interest expenses are costs related to holding derivative securities. All derivatives have an interest rate built into their pricing. This rate, known as the risk-free rate, is very close to the short-term rate on U.S.government securities. Buying and selling these derivatives also results in transaction expenses.

Interest and transaction expenses can be hard to identify and calculate because they are not individual line items, but instead a gradual reduction of fund profitability. One approach that works well is to compare a leveraged ETF's performance against its underlying index for several months and examine the differences between expected and actual returns.

Example - Measuring an ETF\'s Returns
A two-times leveraged small-cap ETF has assets of $500 million, and the appropriate index is trading for $50. The fund purchases derivatives to simulate $1 billion of exposure to the appropriate small-cap index, or 20 million shares, using a combination of index futures, index options and equity swaps.
The fund maintains a large cash position to offset potential declines in the index futures and equity swaps. This cash is invested in short-term securities, and helps offset the interest costs associated with these derivatives. Every day, the fund rebalances its index exposure based upon fluctuations in the price of the index and on share creation and redemption obligations.
During the year, this fund generates $33 million of expenses, as detailed below.
Interest Expenses $25 million 5% of $500 million
Transaction Expenses $3 million 0.3% of $1 billion
Management Expenses $5 million $1% of $500 million
Total Expenses $33 million - -

In one year, the index increases 10%, to $55, and the 20 million shares are now worth $1.1 billion. The fund has generated capital gains and dividends of $100 million and incurred $33 million in total expenses. After all expenses are backed out, the resultant gain, $67 million, represents a 13.4% gain for the investors in the fund.

On the other hand, if the index had declined 10%, to $45, the result would be a very different story. The investor would have lost $133 million, or 25% of his invested capital. The fund would also sell some of these depreciated securities to reduce index exposure to $734 million, or twice the amount of investor equity (now $367 million).

Note: This example does not take into account daily rebalancing, and long sequences of superior or inferior daily returns can often have a noticeable impact on the fund's share holdings and performance.

The Bottom Line
Leveraged ETFs, like most ETFs, are simple to use but hide considerable complexity. Behind the scenes, fund management is constantly buying and selling derivatives to maintain a target index exposure. This results in interest and transaction expenses and significant fluctuations in index exposure due to daily rebalancing. Because of these factors, it is impossible for any of these funds to provide twice the return of the index for long periods of time. The best way to develop realistic performance expectations for these products is to study the ETF's past daily returns as compared to those of the underlying index.

For investors that are already familiar with leveraged investing and have access to the underlying derivatives (e.g. index futures, index options, and equity swaps), leveraged ETFs may have little to offer. These investors will probably be more comfortable managing their own portfolio, and controlling their index exposure and leverage ratio directly.

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