What if I tell you when the index/market moves DOWN by 1%, your investments could potentially move UP by 3%.
Welcome to the world of Leveraged ETFs!!!
What is Leveraged ETFs?
Leveraged ETFs are financial products that give an investor amplified market exposure. The magnitude of the amplified market exposure varies from double leveraged to triple leveraged. As the name implies, double leveraged would give an investor double the market exposure. When the market increases by 1%, the double leveraged ETF increases by 2%. Similarly, triple leveraged would give an investor triple the market exposure.
Not all leveraged ETFs move in tandem with the market, i.e. when the market moves up, the leverage ETF moves up as well. Inverse ETFs move in the opposite direction of the intended market/index.
Similarly, there are inverse double leveraged ETFs and inverse triple leveraged ETFs.
The Mechanics of Leveraged ETFs
To achieve amplified market exposure, leveraged products make use of derivatives.
The most common types of derivatives used to achieve the amplified market exposure are index futures, equity swaps and index options. A derivative is a financial product with a value that is derived from an underlying financial asset or a group of financial assets.
Derivatives are considered as complex products. Mainly because the derivative itself has no intrinsic value as its value is dependent upon the underlying assets. If the value of the underlying asset is difficult to price, i.e. there is no liquid market to price the security, the value/price of the derivative that is dependent upon the said underlying asset will be even harder to determine.
Types of Leveraged ETFs
The most common type of leveraged ETFs is the broad-market based ETFs. For example, the S&P 500 Index is widely considered as the general market indicator for the US stock market. If the general market is rallying, leveraged ETFs that are benchmarked against the general market would do very well.
An example of a triple leveraged ETF that tracks the S&P 500 Index is the ProShares UltraPro S&P500 (UPRO). It provides investors with 3 times the exposure to the S&P 500 Index.
Coming from the same fund issuer, we have the ProShares UltraPro Short S&P500 (SPXU). SPXU is an inverse triple leveraged ETF that tracks the S&P 500 Index.
When the S&P 500 moves up by 1%, UPRO will gain 3% and SPXU will lose 3%. Similarly, when the S&P 500 moves down by 1%, UPRO will lose 3% and SPXU will gain 3%.
For more information on UPRO, see: https://www.etf.com/UPRO
For more information on SPXU, see: https://www.etf.com/SPXU
There are leveraged ETFs that track specific sectors. An example of one is the Direxion Daily Technology Bull 3X Shares (TECL). TECL tracks the S&P Technology Select Sector Index and provides investors with 3 times the index exposure.
For more information on TECL, see: https://www.etf.com/TECL
To maintain the targeted amplified market exposure, whether it is double, triple or inverse the market exposure, leveraged ETFs would need to conduct daily rebalancing to ensure that the amplified exposure is consistent to its stated objective.
For example (assumed that the ETF had no expenses for easy calculation);
- Supposed a triple leveraged ETF had $100 million in assets. This would translate to the ETF having a $300 million in market/index exposure
- On the first day, the index goes up by 3%
- The triple leveraged ETF would gain 9%, profiting $9 million
- The ETF would then sell some securities to book the $9 million profit
- At the end of the first day, the ETF is worth $109 million
- On the second day,
- The ETF would need to maintain $327 million (109 * 3) in market/index exposure to be consistent with its objective
- To maintain the triple exposure, the ETF would use the profit from the first day to reinvest back into the market to gain that additional exposure
- First-day index exposure = $300 million (Fund’s asset base = $100 million)
- Second-day index exposure = $327 million (Fund’s asset base = $109 million)
- Additional index exposure on the second-day = $27 million
When the market/index is consistently going up day after day, holding onto a leveraged ETF would make you look a genius and the return would look fantastic (on paper at least).
With back-to-back losing days, that is where the pain really begins. Losses are magnified and compounded. In a market downturn, rebalancing is imperative to ensure that the fund can survive multiple losing days consecutively or even a market crash. However, daily rebalancing would also mean that the fund is locking in trading losses and will leave the fund with a smaller asset base.
With a smaller asset base, the index/market would need to generate a much higher return for the leveraged ETF to regain back to its original asset base level.
The role of expenses and fees in Leveraged ETF
In summary, it is not cheap to operate a leveraged ETF.
Due to the need to rebalance daily, leveraged ETFs tend to have a higher volume of transactions as compared to non-leveraged ETFs. In general, the total expense ratio of a leveraged ETF can be broken down into the following 3 categories;
- Marketing fees, custodian fees, administration fees and etc
- Cost of buying and selling the derivatives
- All things equal, leveraged products would have higher transaction volume as compared to non-leveraged products. And in turn, leveraged products would incur higher transaction cost as compared to non-leveraged products
- Cost of buying and selling the derivatives
- Cost of holding the derivatives (rollover nature of derivatives)
If held over a short period, say less than 1 week, an investor’s amplified return from holding the leveraged ETF could be exactly equal to the amplified return of the index. However, if held over a long period, say months, the actual return from holding the leveraged ETF would not equal to the amplified return of the index as the high cost of operating a leveraged ETF would greatly diminish the fund’s net return.
Should you invest in Leveraged ETFs?
I would not call it investing.
Leveraged ETFs are short-term trading tools and they are meant for active/day traders who want to speculate in the market by taking advantage of the short-term momentum in the market. These are NOT meant for long-term buy and hold strategy. If you are a long-term investor, i.e. not a speculator, stay away from leveraged products. You have no business dealing with leveraged products.
At the end of the day…..
Leveraged ETFs perform as per what they are intended for. To provide investors with amplified market exposure. There is a demand for the product and the fund issuers simply supply it. While fund issuers may have packaged a complex investing strategy into an easily understandable structure, i.e. ETF, the underlying exposure is not for everyone. Definitely not for the mom and pop retail investors.
As always, take personal responsibility of your financial well-being and do your own due diligence.
Disclaimer: This article does not constitute a solicitation to buy/sell any securities that may be mentioned in this article. At the time of writing and publication, the author does not hold any position in any of the securities mentioned in this article. I am writing in my personal capacity and my views do not represent that of any organisations.