What’s better than a good thing? More of a good thing. It’s natural to want more of something we like. And investors like ETFs.

What Is an ETF?

An ETF, or exchange-traded fund, is a security that trades on an exchange. It is a collection of assets that may be comprised of stocks, bonds, commodities, or other investment types. It may track an underlying index like the S&P 500 or a particular sector or industry or it may be completely customized. The potential types of ETFs are nearly infinite.

Leveraged ETFs

ETFs offer diversification, low costs and tax efficiency. Given these attractive features, investors have rushed to embrace them. But should investors embrace leveraged ETFs? The answer depends on the investor, but by definition, the use of leverage involves higher risk.

The returns of an ETF are designed to match the returns of the securities the ETF is tracking. For example, the SPDR S&P 500 ETF will deliver the same returns as the S&P 500 Index. A leveraged ETF seeks to amplify the daily price changes in the underlying assets through the use of options or debt. The ratio for most leveraged ETFs is usually 2:1 or 3:1. For example, the ProShares Ultra S&P 500 ETF seeks to double the returns of the S&P 500. Thus, if the S&P 500 returns 5%, the ProShares Ultra S&P 500 ETF should return 10%.

Leveraged ETFs can be long or short. A leveraged short ETF offers investors a chance to make money when the price of the underlying index drops. For example, the Direxion Daily S&P 500 Bear 3x Shares delivers three times the inverse performance of the S&P 500 – if the S&P 500 decreases 10%, the return to the investor would be a gain of 30%.

What's the Catch?

As attractive as these potential returns sound, there is a catch.

Leverage is a double-edged sword – it can enhance returns on the upside but it can also worsen losses on the downside. If the S&P 500 is down, the ProShares Ultra S&P 500 ETF will be down twice as much.

But that’s not the only catch.

The returns of a leveraged ETF try to match the returns of its underlying assets on a daily basis. At the end of each day, the leverage must be adjusted to account for the price changes in the underlying securities in order to maintain constant exposure. This means that some options may need to be bought or sold to maintain the same multiple (2x or 3x) to the underlying assets. As a result, leveraged ETFs may not perfectly track the performance of the underlying assets over longer time periods. For this reason, leveraged ETFs are more suitable for traders looking to make a short-term bet, rather than for buy-and-hold investors.

Potential for Outperformance

Despite this, investors may be lured by the potential outperformance leveraged ETFs offer in a trending market. In the absence of volatility, it is possible for a leveraged ETF to outperform its expected return. The reason for this relates to the need for the daily rebalancing noted above. A leveraged ETF is essentially marked to market at the end of the day, and the following day is a clean slate.

Over time, the daily results compound and in a trending market, this allows a leveraged fund to outperform its stated ratio in a rising market and to underperform its ratio in a declining market. For example, if an index increased 5% a day for 10 days from a beginning level of 100, the cumulative return would be 63%. The expected return for a 2x levered ETF would be 126% ­– however, given compounding, the actual return would be 159%.

If the same index decreased 5% a day for 10 days, the expected return for the index would be a loss of 40% and a loss of 80% for the 2x leveraged index. However, due to compounding, the levered index return would actually be a loss of 65%.

Volatility Risks

Although some investors might be tantalized by these possible returns, markets are typically volatile. And it’s in volatile markets that a leveraged ETF can provide a shortcut to rapid losses.

If over that same 10-day period, the index experienced a succession of days where it rose 5% and then fell 5%, the cumulative return to the market would be a loss of 1%. But rather than returning the expected loss of 2%, the leveraged ETF would deliver a loss of 5%.

It is exceedingly difficult to predict which direction the market will move on a daily basis, let alone on a succession of days, and any strategy that requires such a forecast is high risk. Another way to think about this is that options are typically short-term trading securities that have expiration dates. Thus, investors should view any strategy that uses options for leverage as short-term and risky in nature.

Costs of Leveraged ETFs

If the dangers of leverage and compounding are not enough to give one pause, investors should be aware that leveraged ETFs have higher management fees and transaction costs than unleveraged ETFs. Management fees for many leveraged ETFs are typically 1% or higher. For example, the management fee for the ProShares Ultra S&P 500 ETF is 0.90% while the fee for the SPDR S&P 500 ETF is only 0.0945%. The higher costs are due to option premiums as well as interest costs used on debt for leverage or margin purchases. Higher fees create a higher drag on performance.

Leveraged ETFs offer highly risk-tolerant traders an instrument to bet on short term moves in the markets. But given the risks and costs involved, the typical investor would likely be better off steering clear.