What is an 'Ultra ETF'

Ultra ETFs are a class of exchange-traded fund (ETF) that employs leverage in an effort to achieve double the return of a set benchmark. The first ultra ETFs appeared in 2006 and the class has 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.

BREAKING DOWN 'Ultra ETF'

According to the prospectuses for these funds, ultra ETFs may not achieve double 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 achieve twice the daily return, which they have done fairly accurately in the short time they can be analyzed. To create leverage, these ETFs use financial derivatives.

Ultra ETFs, also known as leveraged ETFs or geared funds, can be beneficial to tactical investors who are short on capital or allocation space within a diversified portfolio. For example, they can invest 5% of their portfolios into an ultra ETF and gain closer to 10% exposure due to the leveraged returns.

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. The expense ratios also run much higher than for standard ETFs, as most charge 0.95% of the total assets.

Ultra ETFs have expanded from an original objective of doubling the long performance of a given index to offer products with triple the leverage or more as well as inverse ETFs that short index performance and can double those shorts with the use of leverage. When used properly, inverse ETFs allow sophisticated investors to hedge existing long positions with short exposure.

Limitations of Ultra ETFs

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. 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.

The inherent and often misunderstood risks of leveraged ETFs caused the U.S. Securities and Exchange Commission to put on hold a decision to approve quadruple leveraged ETFs after initially greenlighting these new products.  

Ultra ETFs represent just a small portion of the total ETF universe. As of March 31, 2018, ultra ETFs held global assets of approximately $70 billion, or 1.5% of the $4.8 trillion total ETF market according to Bloomberg. Ultra ETFs are more prevalent in Asian markets, where they represent 40% of ETF assets in Taiwan, 21% in South Korea and 2.9% in Japan.

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