What Is an Ultra ETF?
An ultra ETF is a class of exchange-traded fund (ETF) that employs leverage in an effort to amplify the return of a set benchmark. Since first arriving on the scene in 2006, ultra ETFs have grown to include different ETFs with underlying benchmarks ranging from broad market indexes, such as the S&P 500 and Russell 2000, to specific sectors, such as technology, healthcare, and basic materials.
Ultra ETFs are also known as leveraged ETFs or geared funds.
- An ultra ETF is a class of exchange-traded fund (ETF) that employs leverage in an effort to amplify the return of a set benchmark.
- They use financial derivatives and debt to increase the impact of price movements, offering to double, triple or more the long or short performance of a given underlying index.
- Due to the high-risk, high-cost structure of ultra ETFs, they are best suited to quick trading strategies.
Understanding an Ultra ETF
ETFs are funds that invest in a basket of securities from the index that they track. They generally aim to achieve the same returns as their benchmark by replicating its holdings, offering investors the opportunity to mimic the performance of the broader equity market or, in other cases, gain complete exposure to a specific sector or trend.
A traditional exchange-traded fund usually tracks the securities in its underlying index on a one-to-one basis, meaning that if, for example, the S&P moves 1 percent, an S&P ETF will also move by 1 percent. Alternative ones, often referred to as ultra ETFs, seek to be more aggressive. These marketable securities use financial derivatives and debt to amplify returns, offering to double, triple or more the long or short performance of a given underlying index.
Leveraging is an investing strategy that involves using borrowed funds to buy options and futures to increase the impact of price movements.
Increased daily volatility is both the biggest benefit and greatest danger of ultra ETFs. They are best suited to short-term investing strategies or quick trading to maximize a given bet in the market — due to the high-risk, high-cost structure of ultra ETFs, they are rarely used as long-term investments.
According to the prospectuses for these funds, ultra ETFs may not achieve double or more the return of the benchmark during flat markets. Long-term returns may also diverge from the desired performance target. The ultra ETFs' only aim is to amplify the daily return — a goal they have succeeded in fairly accurately in the short time they can be analyzed.
Benefits of an Ultra ETF
If an investor is convinced, say, that the S&P 500 is about to rise, he or she will probably want to explore ways to make as much money as possible from this conviction. An ultra ETF can cater to those needs, without incurring the additional expenses and stress of trading on margin — a process whereby a broker lends money to a customer so that he or she can purchase stocks or other securities with the securities held as collateral for the loan.
Ultra ETFs can be beneficial to tactical investors who are short on capital or allocation space within a diversified portfolio. For instance, they can invest 5 percent of their portfolios into an ultra ETF and gain closer to 10 percent exposure due to the leveraged returns.
Limitations of an Ultra ETF
Leverage is a double-edged sword: It can lead to significant gains, as well as significant losses. The use of leverage magnifies not only the return potential of these ETFs but also the standard deviation, making these investments riskier than non-leveraged ETFs targeting the same index or investment style. In other words, these vehicles are not for the average investor.
Ultra ETFs represent just a small portion of the total ETF universe, accounting for approximately $49 billion, or 3.6 percent of the $1.4 trillion total ETF market as of January 2021.
Anyone looking to make long-term, buy and hold investments should also steer clear of ultra ETFs. Daily rebalancing and compounding, combined with leverage, will cause investment results to diverge significantly over time from expectations. This is due to the wide variance of performance that make standard performance measures such as the geometric mean of limited use.
Potential payoffs can be significantly impaired by charges, too. Because of their complexity and use of borrowed funds, ultra ETFs carry much higher expense ratios than standard ETFs. The average fee for regular ETFs is roughly 0.5 percent, or $5.00 for every $1,000 invested in January 2021. Ultra ETFs, on the other hand, usually come with expense ratios of 1 percent or more.
Ultra ETFs also enable investors to amplify their returns when shorting, or betting against, an underlying index.
Inverse ultra ETFs, or ultra shorts, use leverage to make extra money when a market declines in value. When used properly, they allow sophisticated investors to hedge existing long positions with short exposure.