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.
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.
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:
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.
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.
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.
Due to this daily rebalancing, ETFs are only worth trading for the short term. They’re not long-term investments.
If you haven’t changed your mind yet, here’s how to buy leveraged ETFs:
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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