If you're looking to maximise your potential returns, trading leveraged ETFs can offer some killer advantages compared to other other forms of investing with leverage, but there are also some key pitfalls to watch out for.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.Between 51%-76% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
The prospect of large gains for a small outlay is investing nirvana. Even the most frugal and risk-averse investors would love to find that one investment that generates returns equal to many multiples of the initial investment. This is the lure of leveraged trading, it gives outsized exposure for a small upfront sum.
What’s particularly attractive and rising in popularity amongst the global investing community is using a specific type of asset to reap these potential rewards. Leveraged ETFs – welcome, to another edition of Thunderdome!
What is a leveraged ETF?
Leveraged exchange-traded funds (ETFs) use financial derivatives and debt to magnify the returns from an underlying index or asset.
Most ETFs deliver the performance of an index on a one-to-one basis. Leveraged ETFs, in contrast, may raise that to 2:1 or 3:1. That means that if the underlying asset goes up 10%, the investor gets 20%, but the same is true on the downside.
With leverage, investors don’t have to tie up as much capital to get the higher exposure they want, or liquidate assets elsewhere to fund ETF positions. They can back their positions with real conviction, meaning time spent on research goes further.
However, leverage needs to be handled with care. An investor’s hunch many be right and they may make many times their initial investment, but it can also be a quick way to lose cash because losses are also magnified. As such, investors may need to put parameters around their trading positions, based on how much they can reasonably afford to lose.
Types of leveraged ETFs
Leveraged ETFs are available for most indexes, such as the S&P 500 or say the Nasdaq 100. Or if you prefer to dabble in the UK stock market, you can also find leveraged ETFs that focus on the FTSE 100 index.
These unique ETF investments are also available for commodities and currencies. It is also possible to get leveraged ETFs tracking market volatility – like the Vix index or ‘fear’ gauge.
Can inverse ETFs be leveraged?
Yes, there are also leveraged inverse ETFs. Inverse ETFs make money when the index or asset is falling and leveraged inverse ETFs magnify those gains.
They’re particularly useful if you’re feeling bearish about a particular asset, market or index. A leveraged inverse S&P 500 ETF, for example, would have made a lot of money during a stock market crash. However, it would struggle in the many times when the index is marching upward.
Best leveraged ETFs in the UK
If you want to check out some of the best-performing leveraged ETFs, take a look at the options below.
Just keep in mind that leveraged ETFs involve borrowing money to maximise gains or losses. What’s more, these aren’t necessarily the best leveraged ETFs to buy in the UK today. Past performance doesn’t dictate future results. The under-performers may do well over the next few years.
Table: sorted by 1-year performance based on data from JustETF.com
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
How do leverage ETFs work
Leveraged ETFs will typically use derivatives to achieve the extra exposure to a particular index or asset. These may be index futures, equity swaps, or index options. These derivatives have a cost and therefore leveraged ETFs tend to be more expensive than normal ETFs.
A typical expense ratio may be 0.5% rather than 0.1%. A leveraged index fund will also need to include cash invested in short-term securities to meet any financial obligations that arise from losses on the derivatives.
Our expert says: What's the best way to use leveraged ETFs?
"Realistically, if you’re interested in leveraged ETFs, you should be using them as a tool and not to form the core of your portfolio. These ETFs can be extremely useful during periods where you’ve done plenty of research and have conviction about which way the market is moving. However, it’s important to stay humble – and diversified. Overexposing yourself is never a good idea (especially when it comes to investing).
Diversification is the best way to make sure your portfolio will stand the test of time, don’t risk getting wiped out by leaning too hard in one direction. Leveraged ETFs can be an excellent tool to have in your arsenal, but don’t ignore the risks and think carefully about whether or not they align with your own personal investing strategy and risk appetite."
If the underlying asset moves in the right direction, you can make many times your initial investment. Taking the example of a position with 3:1 leverage: if you wanted £30,000 worth of exposure, you only need an upfront investment of £10,000 for a 3x leveraged ETF.
If the index rises 25%, you’d make £10,000 x 75%, leaving you with £17,500. Had they been in a normal ETF, they would have had to put in £30,000 upfront to make the same £7,500 return. However, the opposite is also true. If the index falls 25%, you’d lose 75% of your initial investment – leaving you with just £2,500. If you’d put £10,000 in normal ETF, you’d still have had £7,500.
How does this compare to margin trading?
For margin trading, the potential gains are far greater, as are the potential losses. If an investor wants the same £30,000 worth of exposure, with a margin level of 5% they will only have to make an initial investment of £1,500. If the current share price is £100, they are holding the equivalent of 300 shares.
If those shares rise to £150, the trader makes £50 x 300 or £15,000 – ten times their original investment. However, had the trade gone against them, their losses could have been much more severe. If the share price for the company fell to £50, the investor would have lost £15,000 and would have to find another £13,500. If they decided to keep the position open, the broker may ask for further margin payments.
Why ETFs over other leveraged options?
If you want to attempt to super-charge your investment, using leveraged ETFs can have a number of advantages over other forms of leveraged trading:
Investors can’t lose more than they put in. With contracts for differences, investors can lose many multiples of their initial investment if the trade goes against them. With leveraged ETFs, an investor can lose all their initial investment, but no more. As such, it can be a good starting point for more sophisticated leveraged trading strategies.
There are no margin requirements. With other forms of leveraged trading, investors need to put up an initial amount (known as margin). Margin requirements will vary from broker to broker and from asset class to asset class but will typically be less than 10% of the overall exposure. If a position starts losing money, an investor may be required to top up these margin payments. Equally, the broker may wind up the trade if the margin call exceeds a person’s available funds or sell other positions they hold. With ETFs, there are no margin requirements.
They should be less volatile. Anyone who introduces leverage into their investments must be prepared for a more volatile ride. However, leveraged ETFs generally behave in a more predictable way than other forms of leveraged trading, making it easier to keep track of the price fluctuations.
Leveraged ETFs are more complex than normal ETFs. The use of derivatives invariably brings in additional risks, such as counterparty risk for the providers of the derivatives, and collateral risks should the derivatives provider go bust. It’s also important to really drive home the point that your potential losses will be magnified due to the structure of these ETFs.
As it stands many of these ETFs are small and expensive relative to other ETFs. They tend to be used by traders rather than investors, which means they don’t have the widespread appeal that drives assets towards mainstream ETFs. This means dealing spreads can be wider and they are less liquid than conventional ETFs (potentially making them harder to buy or sell). There is also less choice, with leveraged ETFs only available on mainstream equity indices, commodities and currency pairs.
Leveraged trading requires an appetite for risk, but leveraged ETFs can be a gateway in to more sophisticated leveraged trading strategies. Because an investor cannot lose more than their initial investment, they can use leveraged ETFs to hone their trading skills and get to know the market before moving onto to higher risk/higher reward options. It can help investors develop a trading style and understand their strengths and weaknesses.
Pros and cons of leveraged ETFs
Pros
The possibility of maximising investment returns
ETFs can be less volatile than other assets
You won’t lose more than your initial investment
Cons
The possibility of maximising investment losses
Usually higher costs associated with these ETFs
Uses derivatives and are a more complex method of investing
Bottom line
Leveraged ETFs offer an interesting strategy to potentially magnify your returns or take high conviction positions in certain assets. This can deliver higher returns for a small upfront cost. However, like an antique magnifying glass, this products needs to be handled with care. Losses are magnified in the same way as gains, and there are some unique risks to navigate (like counterparty risk).
There is always the potential for unexpected events to derail even the most well-planned trading strategy. You won’t lose more than you put in with leveraged ETFs, but you still need to be realistically about your individual risk appetite and how much you’d be comfortable losing if the markets took a turn for the worse.
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George is a deputy editor at Finder. He has previously written for The Motley Fool UK, Nasdaq, Freetrade, Investing in the Web, MoneyMagpie, Online Mortgage Advisor, Wealth, and Compare Forex Brokers. He's focused on making personal finance and investing engaging for everyone. To do this he draws from previous work and his Level 4 Diploma for Financial Advisers (DipFA), sharing what he’s learnt. When he’s not geeking out about money, you’ll find him playing sports and staying active. See full bio
George's expertise
George has written 155 Finder guides across topics including:
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