As an asset class, exchange traded funds (ETFs) are nearly three decades old with the first ETF having debuted in Canada in 1990. Over the years, the ETF universe has seen an increasing number of exotic products come to market, but the fact remains (and data confirm as much) that a massive percentage of ETF assets reside in plain vanilla, cap-weighted funds tracking familiar indexes.

On the other hand, issuers of ETFs have also proven adept at testing market participants' taste for risk along with a willingness to embrace more exotic fare. One of the more successful ventures on those fronts has been leveraged ETFs. Put simply, the idea of a leveraged ETF is to deliver an increased percentage of a particular index's returns over an intraday time frame.

For example, if the S&P 500 rises by 1% tomorrow, the Direxion Daily S&P 500 Bull 3X Shares (SPXL) should rise by 3%. Triple-leveraged ETFs such as SPXL tend to get most of the attention among leveraged ETFs, but there are also double-leveraged ETFs. For example, ProShares Ultra Russell2000 (UWM) should go up 2% on days when the Russell 2000 rises 1%.

To date, leveraged ETFs have not pushed boundaries beyond triple leveraged. On a related note, a proposal to list quadruple-leveraged ETFs was recently tabled by the Securities and Exchange Commission (SEC) after initially being approved, indicating regulators are applying more scrutiny to geared ETFs.

Inside The Plumbing Of Leveraged ETFs

Leveraged ETFs initially gained acclaim during the global financial crisis. In one of the more spectacular examples of the potency of these products, the Direxion Daily Financial Bear 3X Shares (FAZ) eventually sported a four-digit price tag as bank stocks continued slumping.

The ascent of FAZ during the crisis was perhaps one catalyst that drew traders to leveraged ETFs, but that allure also serves as a cautionary tale. Simply put, leveraged ETFs are designed to be daily trading instruments, not buy-and-hold investments. ProShares and Direxion, the two largest issuers of inverse and leveraged ETFs, tell investors as much. In fact, those issuers and others are blunt and direct in telling investors that geared ETFs often deliver on their stated objectives over a single trading day, but holding these products for weeks and months can lead to returns that deviate wildly from those of the fund's underlying index.

“Leveraged and inverse ETFs pursue daily leveraged investment objectives which means they are riskier than alternatives which do not use leverage,” according to Direxion. “They seek daily goals and should not be expected to track the underlying index over periods longer than one day. They are not suitable for all investors and should be utilized only by investors who understand leverage risk and who actively manage their investments.”

In plain English: A trader that holds an ETF like FAZ for an extended time frame, even as bank stocks fall, could actually lose money. The reason is there are some complex mechanics involved in how leveraged ETFs become leveraged and those mechanics are fine-tuned on a daily basis.

So if a triple-leveraged ETF has $100 million in assets, the issuer has to purchase $300 million of net exposure to that fund's underlying index. If the index goes up 1%, meaning the leveraged ETF rises 3%, the assets rise to $103 million and the gross exposure rises to $303 million.

“Since gross exposure must always equal 300% of net assets ($103 million in net assets x 300% = $309 million) at the beginning of each trading day, $6 million of exposure must be added to the portfolio,” adds Direxion.

Inverse ETFs and Inverse Leveraged ETFs

Investors should also note there are significant differences between inverse ETFs and inverse leveraged ETFs.

Notably, there are plenty of inverse ETFs on the market today that are not leveraged products. For example, traders holding the ProShares Short S&P500 (SH) on a day when the S&P 500 falls 1% should make 1% on their money. On the other hand, traders that own the Direxion Daily S&P 500 Bear 3X Shares (SPXS) will make 3% on a day when the S&P 500 declines 1%.

In theory, inverse ETFs that are not leveraged are safer than their leveraged counterparts. If nothing else, a non-leveraged inverse ETF is apt to be significantly less volatile than a leveraged inverse equivalent. However, issuers of inverse but not leveraged ETFs still encourage investors to use these products on an intraday basis.

Assets Available With Leveraged ETFs

Active, sophisticated traders can tap multiple asset classes and sectors with inverse and leveraged ETFs. Direxion alone offers four triple-leveraged bond ETFs and 15 triple-leveraged, including inverse products, international ETFs. The ProShares lineup of inverse and leveraged ETFs, beyond equity funds, includes commodities, currencies and fixed income products.

Some of these products are among the most heavily traded ETFs of any type in the U.S. The most heavily-traded leveraged ETFs include the ProShares Ultra VIX Short-Term Futures ETF (UVXY), the Direxion Daily Junior Gold Miners Index Bull 3X Shares (JNUG) and the Direxion Daily Small Cap Bear 3X Shares (TZA).

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