Leveraged ETFs: The Potential for Big Gains—and Bigger Losses

What Is a Leveraged ETF?

A leveraged exchange traded fund (LETF) is a security that uses financial derivatives and debt to amplify the returns of an underlying index or other assets it tracks. Some leveraged or "geared" ETFs track single stocks and crypto market or futures prices, which can make an already volatile trading strategy far more combustible.

While a traditional ETF typically tracks the securities in its underlying index on a one-to-one basis, an LETF will typically aim for a 2:1 or 3:1 ratio. These products are available for most indexes, such as the Nasdaq 100 Index and the Dow Jones Industrial Average.

Understanding Leveraged ETFs

ETFs sell like other securities on the stock market and contain a basket of securities. These securities could be from an index they track, a hand-picked theme of stocks, or individual stocks, derivatives, fixed-income securities, and currency. For example, ETFs that track the S&P 500 Index typically contain the 500-plus stocks in the S&P 500. So, if the S&P moves by 1%, the ETF will also move by 1%.

An LETF that tracks the S&P 500 would use financial products and debt that magnify each 1% gain in the S&P to a 2% or 3% gain. The extent of the gain depends on the amount of leverage used. Leveraging is an investing strategy that uses borrowed funds to buy futures and other derivatives to increase the impact of changes in price. LETFs primarily use futures contracts, index futures, and swap agreements to magnify the daily returns of the underlying index, stock, or other tracked assets. These derivatives are needed for the daily rebalancing these LETFs require.

This leverage can work in the opposite direction and lead to magnified losses. If the underlying index falls by 1%, the loss is exaggerated by the leverage. Investors should be aware of the risks of LETFs since the risk of loss is far higher than that of traditional investments. As D.J. Abner notes in his "ETF Handbook," while investors notoriously fail to read prospectuses and investor warnings before putting money into securities, investing in an LETF is decidedly not the time to do so.

Lastly, the management fees and transaction costs associated with LETFs can diminish the fund's return. For the 191 LETFs it tracks in the U.S. markets, ETF.com puts the average expense ratio at 1.04%.

The Leverage in Leveraged ETFs

An LETF applies derivatives to magnify the exposure to a particular index or other targeted asset (stocks, cryptocurrency, commodities, etc.). Most do not aim to amplify the monthly or annual returns of the target assets but instead track daily changes, resetting each day. However, longer reset periods, such as one month, can be used.

The leverage in LETFs comes from several sources. First, it can come from borrowing. For instance, the fund that aims to have twice the return of the targeted assets might take your invested funds and then borrow the same amount to effectively double how much is invested. LETFs also employ derivatives like forward contracts, futures contracts, total return swaps, and, less frequently, options:

• Futures contracts: These are agreements to buy or sell an asset at a predetermined price at a specific time. They are traded on exchanges, and the parties have to fulfill the contract at its maturity date.
• Forward contracts: Like futures, forwards are contracts to trade an asset at a set price in the future. However, unlike futures, they are not standardized but are customizable private agreements.
• Total return swaps: One party agrees to pay the total return, including dividends, interest, and capital gains of a tracked asset or set of assets to another party that pays a fixed or floating rate. It's a way to gain exposure to an asset's return without owning it.
  
• Options: Options contracts grant an investor the ability to buy (a call option) or sell (a put option) an underlying asset without the obligation to buy or sell the security. Options contracts have an expiration date. They are fundamentally different from futures and forwards, which put obligations on both parties, and differ from swaps, which involve exchanging cash flows or returns.

Employing derivatives for generating returns is a method known as "synthetic replication" (the flip side of "physical" replication, directly borrowing), which is generally more efficient than borrowing to buy the securities of the benchmark. Regarding options, they have upfront fees called premiums that allow investors to buy many shares of a security. As a result, options layered with investments, such as stocks, can add to the gains for LETFs over 1:1 traditional ETFs.

A leveraged inverse ETF attempts to use its leverage to make money when the underlying index is declining in value. In other words, an inverse ETF rises while the underlying index is falling, allowing investors to profit from a bearish market or market declines.

The Costs of Leverage

Along with management and transaction fee expenses, there are other costs associated with LETFs. These funds have higher fees than non-leveraged ETFs because premiums, fees, and interest need to be paid on the derivatives and for margin costs. Many LETFs have expense ratios of 1% or more.

Despite the higher expense ratios associated with LETFs, they are often less expensive than other forms of margin. Trading on margin involves a broker lending money to a customer so that the borrower can buy securities with the securities held as collateral for the loan. The broker also charges an interest rate for the margin loan.

For example, short selling, which involves borrowing shares from a broker to bet on a downward move, can carry fees of 3% or more on the amount borrowed. Using margin to buy stock can become similarly expensive and can result in margin calls should the position begin losing money. A margin call happens when a broker asks for more money to shore up the account if the collateral securities are losing value and fall below a certain minimum.

Leveraged ETFs Are Short-Term Instruments

LETFs are typically used by day traders speculating on an index or other targeted sets of assets. It is difficult to hold long-term investments in LETFs because the derivatives used for the leverage are not long-term investments. As a result, traders often hold positions in LETFs for day trading.

These ETFs should not be used for long-term strategies since they're anchored in techniques for returns within a trading day, not a longer time, and the daily reset means the fund can't build on itself. If you want ETFs for long-term investing, there are myriad financial products designed for this strategy.

Leveraged ETF Pros and Cons

Real World Example of a Leveraged ETF

The Direxion Daily Financial Bull 3x Shares (FAS) ETF holds equities in large U.S. financial companies. It has an expense ratio of 0.94%, and it tracks securities listed on the Financial Select Sector Index (IXMTR, an index of financial sector stocks listed on the S&P 500) and includes Berkshire Hathaway (BRK.B), Visa (V), JPMorgan Chase & Co. (JPM), and other financial sector companies. This LETF aims to provide investors three times (3x) the return on the moves in the financial stocks it tracks. To do this, the fund invests in swap agreements and securities.

For instance, suppose an investor bought $10,000 of FAS, and the underlying financial stocks rose by 1% in a single day; FAS would provide 3% returns on that day. This means the $10,000 investment would increase to $10,300 at the end of the day before fees.

Conversely, if the tracked financial stocks declined 2% in a day, FAS would post a 6% decline for that same day. So, the original $10,000 investment would decrease to $9,400 before accounting for fees.

As this example shows, the multiplier works both ways. You can get multiplied gains during a positive performance and multiplied losses when the index declines.

The Impact of Daily Resets

The daily reset mechanism causes LETFs to rebalance their portfolios daily to maintain their leverage. Thus, they won't necessarily work for a buy-and-hold strategy since their returns are a function of maintaining debt to equity within each fund. This resetting effect allows the ETF to seek 3x leverage daily but can cause longer-term returns to diverge significantly from simply compounding the underlying index's returns.

To demonstrate this, here is an example covering several days. Let's assume the underlying financial index FAS tracks has the following daily returns:

• Day 1: +1.0%
• Day 2: -2.0%
• Day 3: +0.5%

We need to triple each of these for the expected return of FAS, respectively, for the three days above:

• Day 1: +3.0%
• Day 2: -6.0%
• Day 3: +1.5%

On Day 1, since the index rose 1%, FAS would seek to provide 3x that return. So the $10,000 investment would rise to $10,300. Because the index rose 1%, the fund's debt-to-equity would be 299% rather than the target of 300%. The fund would need to be reset (rebalanced) because the value of the underlying increased by 1% while debt remained the same (ignoring any fees and interest for simplicity). The fund would borrow more funds or buy more stocks (or both) to bring the leverage back to 300%.

But on Day 2, the index fell 2.0%. So, FAS would target returns of 3 x -2% = -6%. The $10,300 balance would decline by 6% to $9,682. However, because the value of the fund's stocks fell, it would be out of balance at 302% without resetting at the end of the day. Thus, it would need to sell stocks, repay debt, or do both to balance its debt-to-equity ratio.

On Day 3, the index rose 0.5%, so FAS would attempt to return 3 x 0.5% = 1.5%. So, the balance moves from $9,682 to $9,827, a net loss of 1.73%. The fund would reset its balances appropriately at the end of the day.

Totalling the Results

While the index declined 0.5% over the three days (a three-day loss of -1.5%), the 3x LETF declined more than 1.7% over the same period because of the effects of daily rebalancing. Thus, LETF returns can significantly diverge from a simple multiplier of the underlying index's returns in volatile conditions over those same periods. The sequence of daily gains and losses matters because of the daily reset mechanism.

So, while useful for very short-term trading strategies, LETFs like FAS generally should not be expected to achieve a consistent 3x return compared with the tracked index or assets for longer periods.

The Bottom Line

LETFs are specialized financial instruments designed to deliver multiples of the daily performance of a specific index or asset. They achieve this by using derivatives as leverage, amplifying both gains and losses. Ideal for experienced traders and suited for short-term (i.e., intraday) trading strategies, LETFs are used in scenarios when quick, significant market moves are expected. However, their complex nature and the impact of daily rebalancing make them unsuitable for longer-term investments.

Investors should use caution, as these ETFs entail higher risk and volatility than traditional ETFs. Because of their sensitivity to market fluctuations and the costs associated with their operation, LETFs should be used with a clear understanding of their mechanisms and potential impacts on investment portfolios.