Ultra ETFs can be an extremely valuable trading tool for a nimble investor, but a lot of risk is packaged with the returns. These ETFs can be very beneficial for investors who are short on capital, but they are also unpredictable due to the high amount of leverage and the way in which they can diverge from long-term expectations. (To learn more, see Leveraged ETFs: Are They Right For You?)

TUTORIAL: Exchange-Traded Funds

What Is an Ultra ETF?

An ultra ETF, sometimes referred to as a leveraged ETF, is simply an exchange-traded fund (ETF) that uses leverage. These ETFs often utilize derivatives, options or futures to offer an investor an instrument that produces double, triple or another multiple of the returns of the underlying index or benchmark on a daily basis. (Learn more in Rebound Quickly With Leveraged ETFs.)

ProShares offered one of the very first ultra ETFs in 2006, with the introduction of its Ultra ProShares. As an example, ProShares Ultra S&P 500 (ARCA:SSO) is an ETF that is designed to double the performance of the S&P 500 on a daily basis. So, if the S&P increases 1% on the day, SSO would typically be up around 2% on the day. (To learn more, see How is the value of the S&P 500 calculated?)

When they were initially introduced, the basic index ETFs provided investors with instant diversification and an incredibly convenient tool to get immediate market exposure, without having to create a portfolio of individual stocks. Since their launch, their popularity has grown tremendously. ETFs are also extremely liquid trading instruments with expense ratios (annual operating expenses divided by average annual net assets) that are usually fairly low. Because of their success, many ultra ETFs were then launched to give investors and traders more tools and options to take advantage of market volatility. (Check out ETF Liquidity: Why It Matters for more info.)

Advantages

Leverage – Ultra ETFs allow an investor the potential to generate higher returns with the same amount of capital. This makes them an excellent tool, particularly for short-term traders. A trader with limited capital can now take a relatively small amount of capital and generate substantial percentage returns with an ultra ETF, especially in a volatile market environment, where 3 to 5% returns in a single day are commonplace. A 3% return in the market would equate to a 6% return for a holder of an ultra double ETF.

IRA Benefits - Ultra ETFs are somewhat beneficial for IRA accounts, as they can duplicate the leverage of margin trading where trading in margin is typically banned. Although these ETFs can reproduce the margin effects, it is generally not advisable to use volatile leveraged ETFs designed for day trading inside your retirement account. (Learn about margin trading in our article, Margin Trading: What Is Buying On Margin?)

Easy Short Exposure - The inverse are short ETFs, which allow an easy method to short the market without margin or the requirement to get short approval, which is often the case for stocks.

An Array of Options - There is now a broad selection of ultra ETFs that continues to grow. Ultra ETFs exist for the major indexes, S&P 500 sectors, oil, gold, bonds etc. Every major market (stocks, bonds, commodities, currencies) typically has a corresponding leveraged ETF. In addition, the more leveraged three times ultra ETFs give traders daily returns that are about three times the daily returns of the underlying benchmark.

Hedging – Ultra ETFs can allow a portfolio manager or investor to hedge their portfolio with a single instrument. For example, an investor that is holding a large portfolio of stocks short can simply buy an ultra long ETF if he or she feels that a rally may be approaching, and wants to offset the short exposure without covering his or her positions. They add a lot of flexibility and muscle to an investor's portfolio. Ultra ETFs may only be suitable for hedging for very short time horizons such as one day. However, non-leveraged ETFs are usually better suited if hedging for periods greater than one day.

Disadvantages

Leverage - It is a double-edged sword, as the volatility in some of these instruments can produce not only large gains, but tremendous losses in a short amount of time. For example, ProShares UltraShort Financials ETF (ARCA:SKF), the inverse ETF for the financial sector, hit a high of $303.82 on November 21, 2008, and wildly swung to about $100 just 10 trading days later. Trading these instruments requires constant attention and a strict trading discipline because the losses can be devastating.

Imperfect Tracking - Over longer periods, ultra ETF returns don't match the underlying index. They are only designed to track one-day performance, so holding a leveraged ETF for periods of greater than one day will almost guarantee results that will not mirror the underlying benchmark returns.

Timing Issues - Because timing is critical, leveraged ETFs are more suited for day trading rather than long-term investment.

Cost Issues - The ultra expense ratios tend to be much higher than regular ETFs, so they have a disadvantage on the cost side.

The Bottom Line

Ultra ETFs can prove to be very valuable if you're a flexible and diligent investor, and they can help create leverage in an account that otherwise could not. But, because of their volatility and correlation issues, they are best suited to short-term traders rather than investors. (Learn more information on ETF returns in our article: Dissecting Leveraged ETF Returns.)

Related Articles
  1. Taxes

    11 Things You May Not Know About Your IRA

    These little-known features will help you get the most out of your retirement savings.
  2. Investing Basics

    Achieving Optimal Asset Allocation

    Minimizing risk while maximizing return is any investor's prime goal. The right mix of securities is the key to achieving your optimal asset allocation.
  3. Mutual Funds & ETFs

    4 Ways To Use ETFs In Your Portfolio

    To take full advantage of these vehicles, you need to know how they can fulfill certain strategies.
  4. Mutual Funds & ETFs

    IMF Or ETF: Which Is Right For You?

    Here's what the professionals think about these similar, but critically different, investment vehicles.
  5. Mutual Funds & ETFs

    Introduction To Exchange-Traded Funds

    Get into ETFs and enjoy the benefits of a mutual fund with the flexibility of a stock.
  6. Active Trading

    Diamonds: The Missing Commodity Derivative

    While they may be "a girl's best friend", diamonds haven't made it to the futures market - yet.
  7. Active Trading Fundamentals

    The Short And Distort: Stock Manipulation In A Bear Market

    High-quality stock reports needn't be confused with stock manipulators' dramatic claims.
  8. Fundamental Analysis

    3 Misconceptions About Warren Buffett

    Learn why Warren Buffett is the man behind the curtain and how he is misunderstood regarding the ways he has adapted and changed his investing approach over the years.
  9. Savings

    What Your Credit Score Means for Your Love Life

    Wondering if your significant other wants to commit and is reliable? The Fed might have the answer.
  10. Investing News

    Should You Be Betting with Buffett Right Now?

    Following Warren Buffett's stock picks has historically been a good strategy. Is considering his biggest holdings in 2016 a good idea?
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. Where else can I save for retirement after I max out my Roth IRA?

    With uncertainty about the sustainability of Social Security benefits for future retirees, a lot of responsibility for saving ... Read Full Answer >>
  4. Will quitting your job hurt your 401(k)?

    Quitting a job doesn't have to impact a 401(k) balance negatively. In fact, it may actually help in the long run. When leaving ... Read Full Answer >>
  5. Can a 401(k) be taken in bankruptcy?

    The two most common types of bankruptcy available to consumers are Chapter 7 and Chapter 13. Whether you file a Chapter 7 ... Read Full Answer >>
  6. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center