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What is a 'Leveraged ETF'

A leveraged exchange-traded fund (ETF) is a fund that uses financial derivatives and debt to amplify the returns of an underlying index. Leveraged ETFs are available for most indexes, such as the Nasdaq 100 and the Dow Jones Industrial Average. These funds aim to keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio.

BREAKING DOWN 'Leveraged ETF'

Leveraged ETFs are typically used by traders who wish to speculate on an index, or to take advantage of the index's short-term momentum. Due to the high-risk, high-cost structure of leveraged ETFs, they are rarely used as long-term investments. In many cases, traders hold positions in leveraged ETFs for just a few days or less. Many leveraged ETFs have expense ratios of 1% or more.

Despite the high expense ratios associated with leveraged ETFs, these funds are often less expensive to use than other forms of margin. For example, short selling, which involves borrowing shares from a broker in order to bet on a downward move, can carry fees of 3% or more on the amount borrowed. The use of margin to buy stock can become similarly expensive, and can result in margin calls should the position begin losing money. Interest is also charged on the amount borrowed to purchase stock in a margin account.

Use of Daily Futures Contracts

A leveraged ETF typically uses daily futures contracts to magnify the exposure to a particular index. It does not amplify the annual returns of an index; instead, it follows the daily changes. Using the example of a leveraged fund with a 2:1 ratio, this would mean that each dollar of investor capital used is matched with an additional dollar of invested debt. During a given day, if the underlying index returns 1%, the fund would theoretically return 2%. The 2% return is theoretical, as management fees and transaction costs diminish the full effects of leverage.

The 2:1 ratio works in the opposite direction as well. If the index drops 1%, the loss would then be 2%.

Variety of Leveraged ETFs

ProShares launched the first leveraged ETFs in 2006. In the 10 years since then, the number of leveraged ETFs available in the marketplace has grown to over 200. Most are offered by leveraged ETF specialists ProShares and Direxion. Offerings by these two providers include funds providing both bullish and bearish exposure to a multitude of sectors, markets, securities and currencies. Leveraged ETFs also provide various levels of exposure, such as 125%, 200% and 300% of a given benchmark's daily performance.

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