What Is an ETF With Leverage?

A leveraged exchange-traded fund (ETF) is a marketable security that increases the returns of an underlying index through financial derivatives and debt. Compared to the one-to-one tracking ratio that characterizes conventional exchange-traded funds, leveraged ETFs may strive for a ratio of 2:1 or 3:1. Leveraged ETFs are available for most indexes, including the Nasdaq 100 Index and the Dow Jones Industrial Average.

Utilized ETFs

ETFs are mutual funds comprised of a basket of securities representing the index they aim to replicate. For instance, ETFs that monitor the S&P 500 Index will comprise the 500 stocks comprising the S&P. If the S&P moves by 1%, the ETF will typically move by the same amount. An S&P-tracking leveraged ETF may employ financial instruments and debt that increase the magnitude of every 1% increase in the S&P to 2% or 3%. The magnitude of the profit is relative to the degree of leverage employed in the ETF. Leverage is an investment strategy in which options and futures are purchased with borrowed capital to magnify the impact of price fluctuations.

Nevertheless, leverage can operate in the opposite direction, resulting in investor losses. The impact of a 1% decline in the underlying index is amplified due to the leverage. The utilization of leverage carries with it the potential for substantial profits, yet it can also result in substantial losses. The risk of losses with leveraged ETFs is significantly greater than with conventional investments.

Leveraged ETFs may incur transaction costs and management fees, potentially reducing the fund’s overall return.

Leverage in ETFs Leveraged

A leveraged ETF may increase its exposure to a specific index by utilizing derivatives, such as option contracts. As an alternative to magnifying the yearly returns of an index, it monitors the daily fluctuations. Options contracts allow investors to trade in an underlying asset without assuming the obligation to physically purchase or sell the security. Options contracts stipulate a specific date by which all actions must be executed.

Premiums, which are initial investment charges, are associated with options that enable investors to purchase a substantial quantity of shares in a security. 3 Consequently, adding options to an investment, such as equities, can increase the return on the stock investment. By utilizing options in this manner, leveraged ETFs augment the profits of conventional ETFs. Additionally, portfolio managers may borrow funds to purchase additional shares of securities, thereby increasing their holdings and the potential for profits.

A leveraged inverse ETF generates profits by employing leverage when the underlying index declines in value. Alternatively, an inverse ETF accrues gains during declining underlying indices, enabling investors to capitalize on adverse market conditions or market downturns.

The Dilemma of Leverage

In addition to management and transaction commission expenses, leveraged exchange-traded funds may incur additional expenses. The higher expense structure of leveraged ETFs compared to non-leveraged ETFs is due to the premiums required to purchase option contracts and the cost of borrowing or margining. Several leveraged ETFs have expense ratios of at least 1%.

Leveraged ETFs are frequently more affordable than alternative margin investments, despite their high expense ratios. Margin trading occurs when a broker extends a loan to a client for the borrower to acquire equities or other securities. In exchange for the loan, the client pledges the securities as collateral. The merchant additionally levies an interest rate on the margin loan.

An illustration of this is short selling, which entails obtaining shares from a broker to wager on a decline and may incur charges of at least 3 percent on the borrowed amount. Utilizing margin to purchase stocks can incur comparable expenses and lead to margin calls if the position starts to incur losses. When a margin call occurs, a merchant requests additional funds to bolster the account if the collateral securities depreciate.

ETFs Utilized as Short-Term Investment Leverage

Traders who wish to speculate on an index or capitalize on the index’s short-term momentum typically employ leveraged ETFs. Leveraged ETFs are seldom administered as long-term investments due to their high-cost, high-risk structure.

For instance, options contracts are typically transacted in the short term and have expiration dates. Leveraged ETFs make long-term investments challenging to maintain because the derivatives utilized to generate leverage are not intended for long-term investments. Consequently, traders frequently maintain leveraged ETF positions for a few days or less. Long-term holdings of leveraged ETFs may result in returns that deviate significantly from those of the underlying index.

Pros

• Leveraged ETFs present the possibility of substantial profits exceeding the underlying index.
• Leveraged ETFs enable investors to utilize diverse securities for trading purposes.
• Investors can generate profits during market declines by utilizing inversely leveraged ETFs.

Cons

• Expensive leveraged ETFs may result in losses over the underlying index.
• The expense ratios and management fees of leveraged ETFs are greater than those of conventional ETFs.
• Leveraged ETFs are not investments for the long term.

A Practical Illustration of a Leveraged ETF

The Direxion Daily Financial Bull 3x Shares (FAS) ETF invests in major U.S. financial institutions’ Financial Select Sector Index-tracking equities. Its principal holdings consist of Berkshire Hathaway (BRK.B), Visa (V), and JP Morgan Chase (JPM), and it has an expense ratio of 0.96%. The ETF attempts to generate three times the return of the financial stocks it monitors for its investors.

For instance, if an investor allocated $10,000 into the ETF and the index-tracked stock market appreciated by 1% during that period, the ETF would yield 3%. In contrast, a 2% decline in the underlying index would result in a 6% loss for the FAS during that period.

As previously stated, leveraged ETFs are utilized for short-term market fluctuations and can cause investors to rapidly incur substantial gains or losses.

Conclusion

• A leveraged exchange-traded fund (ETF) boosts the profits of an index by using financial contracts and debt.
• Most of the time, a standard ETF tracks the securities in its underlying index one-to-one. A leveraged ETF, on the other hand, may try for a 2:1 or 3:1 ratio.
• There are two sides to leverage: it can help you make significant gains and hurt you badly.