One of the most difficult things to balance in investing is risk and reward. Investors often get attracted to the opportunities with the greatest potential for return, but these also tend to be the investments with the greatest risk. One security that falls under this umbrella is the leveraged exchange-traded fund (ETF), which uses financial derivatives and debt to increase returns. Traditional ETFs track an underlying index by matching securities on a one-to-one basis. That way, the return for investors is similar to that for the underlying index. With a leveraged ETF, the ratio may be two- or even three-to-one so that returns are doubled or tripled. However, losses are also doubled or tripled.
Breaking Down the Typical Anatomy of a Leveraged ETF
An ETF is a specific type of fund that invests in securities from an index that it tracks. For example, an ETF may track the S&P 500 Index and thus invest in the 500 stocks that are found on that index. This means that a 1 percent gain in the index translates to a 1 percent gain for ETFs. While leveraged ETFs largely do the same, they use financial products and debt to magnify that gain into a 2 or 3 percent one for investors. The actual magnification depends on the amount of leverage used in the ETF. The term “leverage” refers to an investment strategy involving the use of borrowed funds to buy options and futures that increase gains. The unfortunate thing about leverage is that it works both ways. In other words, losses also get magnified.
Leveraged ETFs often use options contracts to increase exposure to a particular index. Importantly, leverage does not amplify the annual returns from an index but rather the daily shifts in price. With an options contract, investors have the ability but not the obligation to buy or sell the underlying security. However, options contracts have an expiration date by which action must be completed. These options make it possible to buy a large number of shares of a particular security. Options layered within a fund can significantly magnify the gains of a particular stock. Portfolio managers also have the ability to borrow money for additional shares of securities to drive profits even further.
The Costs Involved with Shares of a Leveraged ETF
The management fees and transaction costs associated with leveraged ETFs can prove quite high on their own. However, there are other costs that get involved with leveraged ETFs. For the most part, leveraged ETFs have higher fees than their traditional counterparts. This is due to the premiums that need to be paid on options contracts, as well as the cost of borrowing to further one’s position. Borrowing money for further investment is known as margining. Leveraged ETFs tend to have an expense ratio of 1 percent or even more. Despite this high expense ratio, leveraged ETFs are often among the most affordable types of margin. Remember that you will pay interest rates for a margin loan.
A popular form of margining is short selling, which involves borrowing shares from a broker to bet that the stock will decrease in price. The fees involved with this type of margin tend to be at least 3 percent, if not higher. Using margin to buy stock has similarly high fees. Plus, doing this may result in a margin call, which is when the broker asks for the money borrowed once the collateral securities start to lose value. A call can put investors in serious jeopardy. Leveraged ETFs avoid many of these issues and thus could be considered less risky or at least cheaper. However, it is important to recognize that leveraged ETFs have the potential to lose a lot of money very quickly.
How Investors Can Make the Most from Leveraged ETFs
Traders typically use leveraged ETFs to speculate on an index and take advantage of short-term momentum. Many investments are typically made with a long-term viewpoint but this is not typically the case with leveraged ETFs due to the high risk and high cost of the investment. Plus, leveraged ETFs rely on derivatives to create leverage and derivatives themselves have expiration dates and are not designed to be long-term investments. Traders typically hold leveraged ETF positions for a few days at most. Over even a short period of time, the returns from a leveraged ETF may be quite different from those of the underlying index since the amplification happens at the daily level.
When chosen correctly, leveraged ETFs can achieve very high returns depending on the gains of the underlying index. Also, there is the option to use an inverse leveraged ETF, which is designed to make money when the market declines. This fund loses money if the market gains. At the same time, there are serious drawbacks that need to be considered. The losses can be just as high as the gains and you need to ensure that you can survive this level of loss before you invest. Plus, you need to account for the high fees associated with a leveraged ETF as these can quickly cut into profits. Also, if you do not have the time to be an active trader, you should choose an investment that you can hold for longer.