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Your guide to leveraged ETFs

They’re a high-risk alternative to standard exchange-traded funds, but they’re not for everyone.

Leveraged ETFs let you take advantage of short-term moves in underlying indices like the Nasdaq 100 and the S&P 500. That means you must accurately predict the market, and you can multiply your gains if you do. If you’re wrong, you may multiply what you lose.

What is a leveraged ETF?

Similar to standard exchange-traded funds that closely track an index or a basket of stocks, leveraged ETFs move in the same direction as the underlying index they track. The main difference between standard and leveraged ETFs is that the returns — and losses — can be either doubled or tripled when investing in leveraged ETFs.

This type of ETF offers a potentially higher reward than standard ETFs, but with a higher risk. The opposite is also true — you can lose more money than you would investing in nonleveraged ETFs, especially if you hold leveraged ETFs longer than a few days.

Because of this type of ETF’s complexity, beginner investors should either avoid them altogether or be prepared to take the losses if their investment goes the wrong way.

Leveraged ETFs aren’t as simple as they seem

A leveraged ETF uses debt and derivatives — such as swaps or futures — to leverage its exposure to an index. This makes the ETF move twice or three times the index it tracks. Most leveraged ETFs are designed to magnify the benchmark’s returns in one trading day, which makes them an excellent tool for day traders.

However, this also makes it a high-risk investment for those who plan to hold it for the long term. That’s because leveraged ETFs aren’t as simple as they seem. You won’t earn 300% on a triple-leveraged ETF investment if the index moves 100% in one year. Leveraged ETFs are rebalanced daily, meaning the ETF must rebalance its exposure to the index by buying or selling swaps to maintain the 2x and 3x leverage. The value of your position changes with that.

Here’s how that would work in a real-life scenario with a $1,000 investment in a 2x leveraged S&P 500 ETF:

  1. Suppose the S&P 500 moves up 2% in one day. A standard ETF that tracks the index would also move 2%. However, your 2x leveraged S&P 500 ETF moves 4%.
  2. Congratulations, you earned $40! Close the position now and keep your profit. Keep the ETF in your portfolio, however, and things could quickly change.
  3. The S&P 500 drops 4% the next day. Your $1,040 is now 8% (2 x 4%) down. That’s $956 remaining. Cut your losses and invest in something else. But if you keep it, you could lose more.
  4. The S&P drops by another 3% the following day. You’re now another 6% in the red. Your starting $1,000 investment now stands at $898.

In this scenario, you lost $102 (10.2%) in three days. This only shows what daily rebalancing, compounding interest and volatility can do to your account. Of course, if the index rose for a few consecutive days, you would have earned substantially more. But that’s where the risk/reward comes in and whether you’re willing to place the bet.

Inverse leveraged ETFs

There are also inverse leveraged ETFs, also known as short ETFs. These ETFs earn a profit when the underlying index falls and lose when the index rises. In our example, an inverse ETF would have earned 9.8%, turning your $1,000 account into $1,098.

Leveraged ETFs can be expensive

Because leveraged ETFs use debt and derivatives to achieve larger moves than the indices, these ETFs cost more than standard nonleveraged ETFs. For a leveraged ETF, you could pay around 1% annually in what is called an expense ratio. Add in fees and taxes to your short-term transactions and it could easily turn out that it’s not worth it unless you know what you’re doing or you’re incredibly lucky.

Leveraged ETFs are designed for short-term trades

Due to this daily rebalancing, ETFs are only worth trading for the short term. They’re not long-term investments.

Benefits

  • High reward potential. Catch the trend for a few consecutive days and easily beat the annual benchmark index with a single trade.
  • Lower cost compared to trading on margin. Trading on margin comes with interest and the risk of a margin call on rare occasions. By investing in leveraged ETFs, you don’t have to worry about that.

Drawbacks

  • High risk. If you end up on the losing end within a few consecutive days, it may be hard to recover your losses. And if you keep the ETF long enough, the volatility could wipe out your entire account.
  • Fees. Leveraged ETFs cost more than nonleveraged ETFs.

How to buy leveraged ETFs

If you haven’t changed your mind yet, here’s how to buy leveraged ETFs:

  1. Open an account with a broker if you don’t have one.
  2. Fund your account.
  3. Search for the ticker symbol of the leveraged ETF you want to invest in. One you decide what index you want to target, it’s generally a matter of finding those with 2X or 3X in the name.
  4. Enter the number of shares you want to buy and at what price.
  5. Review and submit your order.

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Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.

Bottom line

Investing in leveraged ETFs for the long term can be more of a headache than a benefit. But buying in for a day or two could be worth it. Before you start investing, make sure you understand the risks to avoid surprises.

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