The appeal of exchange-traded funds (ETFs) is simple: They mix the diversification benefits of mutual funds, though some are concentrated, with the ability to trade on an intraday basis. There are now thousands of ETFs to choose from and more are being added on a regular basis.
The purpose of a leveraged ETF is to increase the exposure to and impact from the underlying index or investments in the ETF. For example, a leveraged ETF may attempt to double the return of an index on a daily basis.
Leveraged ETFs are another tool for investors to access leverage in the financial markets. And because purchasing an ETF is as simple as issuing a buy order through your trading account, it is a much simpler process than using options, futures, or trading on margin. In this article, we'll show you some key considerations to watch out for when purchasing leveraged ETFs.
- Exchange-traded funds (ETFs) blend the investment style of mutual funds with the ability to trade on an intraday basis.
- Leveraged ETFs attempt to double or more the return of an index on a daily basis and are another tool in addition to options and margin for investors to access leverage in the markets.
- Investing in leveraged ETFs is risky, as not only are returns amplified but so are losses, making them primarily suitable for experienced investors.
- Investing in leveraged ETFs can be expensive as their expense ratios are higher than regular funds in addition to the taxes and turnover costs that are accrued.
- Leveraged ETFs are typically best used by investors who are using a short-term trading strategy that is seeking to capitalize on daily market movements.
In June 2006, ProShares introduced the first wave of leveraged ETFs, referred to by the company as "ProShares Ultra." The ultra ETFs were designed to double the daily performance of the underlying indexes they track. For example, the ProShares Ultra Dow 30 ETF (DDM) is structured to gain 2% when the Dow Jones Industrial Average gains 1%.
More companies such as Direxion followed suit and now there are 188 leveraged ETFs with over $65 billion in market cap as of May 24, 2021. These funds use a number of instruments to hold positions across asset classes including equity, debt, commodities, and derivatives.
These investments can also be highly concentrated in sectors, for example, the Direxion Daily S&P Biotech Bull 3X ETF (LABU), or focused on certain geographies, like the Direxion Daily FTSE China Bull 3X Shares ETF (YINN).
Do They Deliver?
The idea behind such funds is to take advantage of quick day-to-day movements in different financial markets. ProShares Ultra S&P 500 (SSO) was launched in 2006 with the aim of doubling the returns of the underlying S&P 500. The prospectus of the fund clearly lays out that the intention is to double the daily return and not over the long term.
In fact, it goes on to say that for periods longer than a single day, the fund could lose money if the underlying index remains flat or even sometimes when it rises.
On a daily basis, the return of the ultra ETFs has been fairly accurate. For example, the ProShares Ultra S&P 500 fund has tracked the S&P 500 accordingly on a daily basis. When the index has been up, the fund's returns have been higher for 1Q 2021. Similarly, when the index has been down, the losses have been higher.
Regulators, SEC and FINRA, in a 2009 alert clarifying this for individual investors said, "Some investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives."
In theory, a leveraged ETF that returns twice that of the S&P 500 would have generated annual returns of over 13.9% over the last ten years. The performance of the ProShares Ultra S&P 500 fund has been close to reaching that target, with a 10-year return of 23.2% as of March 31, 2021.
Keep Costs in Mind
While an investor can shell out high management fees (such as the 0.91% expense ratio for the ProShares Ultra S&P 500), there's another factor that could impact the actual returns. There are transaction costs associated with every time the fund buys or sells securities, and taxes if these transactions are taxable.
These costs are typically not accounted for in the annual expenses but are reflected in the fund's performance. Funds that rely on daily rebalancing to make the most of the movements in the market would typically have a higher portfolio turnover, meaning more transactions.
Leveraged ETFs are typically best used by investors who are using a short-term trading strategy. Traders who are seeking to capitalize on daily movements—either in the market or in a specific sector—are able to use the ultra ETFs to gain leverage. Because the ultra ETFs give short-term traders the leverage needed on a daily basis without the negative compounding error, most will get in and out within a day.
The ultra ETFs can also be helpful to investors who would like to gain overexposure to a specific sector or index but do not have the required capital.
For example, suppose that an investor is 95% invested in a diversified allocation but is lacking exposure to the utility sector. The investor's goal is to invest 10% of their portfolio into semiconductors; however, with only 5% in cash, it might appear impossible.
The investor can use the 5% cash available to purchase a leveraged ETF that invests in semiconductors such as Direxion Daily Semiconductor Bear 3X Shares ETF (SOXS) and, in reality, give the portfolio a 10% allocation to the sector.
Advantages and Disadvantages of Leveraged ETFs
The advantages of leveraged ETFs are:
- They offer a way to use leverage without using options or margin.
- They are available in retirement accounts.
- They are a great trading tool for short-term traders.
The disadvantages associated with leveraged ETFs include:
- Aim to generate daily returns, not long-term performance.
- The impact of negative compounding can result in long-term inaccuracy.
- High portfolio turnover could dampen returns further.
- Leveraged ETFs are high-risk investments that could be dangerous to the uneducated investor.
The Bottom Line
Leveraged ETFs can be a great way to enhance returns on a daily basis but are not suitable to novice investors, mainly due to the high risks associated with their investment strategies; not only are gains amplified but so are losses.
Overall, leveraged ETFs may be useful only to savvy investors, all others should perhaps stay away or do their due diligence before investing.