What Are Leverage ETFs? Everything You Need to Know

Do you know what leveraged ETFs are all about? Investors use a lot of different strategies to try to beat the stock market as a whole. 

This group includes exchange-traded funds (ETFs) that use debt. A leveraged ETF follows a stock market index, an industry, or a class of assets. 

You can boost the fund's return by using debt. Some risks come with buying shares in a leveraged ETF, which investors should be aware of before making any investment decisions. Let's have an in-depth discussion about it below:

What are leveraged ETFs?

A leveraged ETF is an exchange-traded fund that holds debt and shareholder equity. The debt is available to increase the daily return to shareholders. 

Non-leveraged ETFs, on the other hand, only hold shareholder-leveraged equity and track an index or asset class to try to match the performance of that index or asset class. 

The goal of the fund managers of leveraged ETFs is to make daily returns that are multiples of the index or asset class's performance on which the ETF depends. The goal is to earn higher returns than the cost of taking on the debt.

Options and futures contracts are two types of derivatives that leveraged ETFs can use to boost returns. Inverse leveraged ETFs use derivatives to make the daily return of an index or asset class the exact opposite of what it is. 

Like short-sellers, people who think the value of an index or asset class will go down can buy shares in an inverse leveraged ETF. Some inverse leveraged ETFs try to make a daily return that is the opposite of what an index or asset class is making.

How does leverage ETFs work?

Leveraged ETFs are collective investment funds, which means that a lot of people's money is put into one investment. They are available to multiply the short-term performance of a specific stock market, index, or commodities, like the FTSE 100 index or the price of gold. 

Like stocks, they are traded on a real-time exchange and have real-time market prices.

For example, look at an FTSE 100 2x daily leveraged ETF. It tries to do twice as well as the FTSE 100 index regarding how much it changes daily. If the index goes up by 5%, the ETF will also go up by 10%. In the same way, if the index went down by 5%, the ETF would also go down by 10%.

That is an example of a position that is called "long." But "short" classes can also be taken with inverse ETFs. When investors are short, they make money when the price goes down, not when it goes up.

Most leveraged ETFs track the investment they depend on with derivatives. Derivatives are contracts between two parties, and the contract's price depends on how the asset's value depends on changes.

Who should use leverage ETFs?

Traders often use leveraged ETFs to bet on an index or take advantage of its short-term momentum. So, these ETFs are short-term investments based on speculation.

Leveraged ETFs are unsuitable for the long term because their goal is to boost daily returns. Trade-in option contracts are what make up leveraged ETFs. 

Options contracts have an end date and are only suitable for a short time. So, investors who trade in leveraged ETFs have a short time horizon for their investments. If you keep these ETFs for a long time, their returns may differ from those of the index they track.

Leveraged ETFs are available to take advantage of short-term trends. Because of this, you should only use these ETFs if you are sure about the trend and have a lot of faith in it. 

As was already said, these ETFs can go up or down. Because of this, the plan is a high-risk plan. Because of this, you should only consider investing in leveraged ETFs if you are okay with the level of risk.

Things to consider before investing in leveraged ETFs

Here are some things to think about if you want to invest in leveraged ETFs:

1. Investment horizon

Leveraged ETF funds are suitable for investors who want to put their money to work in the short term. But they may change over time because they try to make the returns bigger daily. Because of this, you should only invest in these ETFs for a short time.

2. Goal of investment 

Before you buy a leveraged ETF, you should know what you want to do with it. They can follow a sector, a theme, or a broad market index. So, please choose a suitable scheme based on how well it fits your investment goals.

3. Previous performance 

Past performance doesn't guarantee future returns. Also, trading derivatives is a hazardous business. But by looking at how the fund has done in the past, you can see how well the fund manager kept the leverage ratios in check.

4. Risk

Exchange-traded funds with debt are high-risk investments. The goal of these ETFs is to boost daily returns. Sometimes bets can work out well, and sometimes they lead to significant losses. Because of this, the value of these ETFs can drop by most or all of their worth. 

Before investing in leveraged ETFs, it is essential to consider the risks that come with them.

5. Expense ratio

The expense ratio of leveraged ETFs is higher than that of regular ETFs. The expense ratio is higher for leveraged ETFs because they trade in financial derivatives. 

These ETFs are also actively managed, which requires a lot of research and technical know-how. Because of this, the fund manager has to charge a higher fee for managing the fund.

Reasons why investing in leveraged ETFs are the best option?

A few excellent reasons to consider when you invest in leveraged exchange-traded funds are:

• Higher returns: These ETFs aim to boost the daily returns of a benchmark index by two or three times. So, they make more money than an ordinary ETF scheme.

• An alternative to derivatives: Leveraged exchange-traded funds give investors indirect access to financial products like options and futures contracts. Dealing with derivatives can be expensive or complicated for most investors. So, investors can use derivatives trading with the help of these ETFs.

• Inverse Leveraged ETFs: Leveraged exchange-traded funds make money when the value of the index goes down. This type of ETF does well when the market falls because it takes short positions.

Are leveraged ETFs more expensive?

Most of the time, leveraged ETFs have higher costs than traditional ETFs. For example, the average cost of running a conventional ETF is 0.45%, while the average cost of running a leveraged ETF is 0.955%. Since these costs come from the fund, they cut into the investor's net return.

Leveraged ETFs: what are their pros & cons?

There are some possible pros to investing in leveraged ETFs, but investors should also be aware of some cons before buying shares.

Pros of leveraged ETFs 

• An alternative to derivatives: Leveraged ETFs give investors indirect access to financial derivatives like options and futures contracts that might be unavailable to them or would be more expensive to trade in other ways.

• They are easy to get into. Like traditional ETFs, shares of leveraged ETFs can be bought and sold on the open market like stocks.

• Possibility of significant returns: Leveraged ETFs boost the daily returns of an underlying benchmark index, giving you more significant gains than regular ETFs.

Cons of leverage ETFs

• Too much market risk: Just as there is a chance for significant gains, there is also a chance for substantial losses. Most leveraged ETFs will lose value over time unless the market moves in the same direction all the time, which is rare.

• High fees: Leveraged ETFs are more expensive to run than traditional ETFs because trading financial derivatives comes with extra costs.

• Not good as long-term investments: Leveraged ETFs are not suitable long-term investments because their goal is to boost the daily returns of a benchmark index. Because of this, they should only be available as short-term investments. Their long-term returns don't match the index, their performance worsens over time, and they don't boost returns similarly.

How dangerous is it to put money into ETFs?

Inverse or leveraged exchange-traded funds (ETFs) can be a part of some common investment strategies, but remember that these types of ETFs carry high risk and are usually unsuitable for new investors. 

Putting money into ETFs can be a good idea, but risks are involved. ETFs are not actively managed most of the time. The trouble is that it's hard to know what will happen, like when a company is bought out or when the index's parts change.

Even though ETFs are made up of many different products and are usually diversified because of this, when you invest can have a significant effect on how much you make. You don't have to support all of your money at once. 

Instead, you can invest little by little over a more extended period. By investing smaller amounts, like once a month or every three months, you'll be less affected by the price you pay at the time of investment. 

Instead, your investment will spread out over a more extended time. Unit cost averaging is the name for this method.

There are a few things you should think about before you start investing. It helps you figure out how much risk you are willing to take and which products are best for you. 

Also, it's not a good idea to invest money that you might need soon or take risks that could put you in a financial bind.

List of 5 leverage ETFs going up in 2022

1. Direxion Daily S&P Biotech Bear 3x Shares (LABD) – Up 60.4%

Direxion Daily S&P Biotech Bear 3x Shares tries to get three times the opposite of the daily performance of the S&P Biotechnology Select Industry Index, which is about those companies in the biotechnology industry that are based in the United States.

Direxion Daily S&P Biotech Bear 3x Shares has $71.8 million in assets and sells about 5 million shares every day, on average. Investors pay 94 bps in fees each year to LABD.

2. MicroSectors FANG & Innovation -3x Inverse Leveraged ETN (BERZ) – Up 49%

MicroSectors FANG & Innovation -3x Inverse Leveraged ETN is tied to the Solactive FANG Innovation Index's three times leveraged inverse performance. The index follows the stock prices of 15 large, liquid U.S. technology companies.

MicroSectors FANG & Innovation -3x Inverse Leveraged ETN has an AUM of $7.4 million, an expense ratio of 0.95 percent, and trades an average of 58,000 shares daily.

3. Direxion Daily Semiconductor Bear 3x Shares (SOXS) – Up 46.9%

Direxion Daily Semiconductor Bear 3x shares focuses on the semiconductor part of the technology sector by giving investors three times the ICE Semiconductor Index's inverse exposure.

Direxion Daily Semiconductor Bear 3x Shares has about $214,3 million in assets and charges 95 basis points per year in fees. On average, 66.7 million shares are traded daily, which is a good amount.

4. Direxion Daily Cloud Computing Bear 2X Shares (CLDS) - Up 44.2%

Direxion Daily Cloud Computing Bear 2X Shares focus on the cloud-computing part of the large technology sector. They give investors twice as much exposure to the performance of the Indxx USA Cloud Computing Index as if it were the opposite.

Direxion Daily Cloud Computing Bear 2X Shares has an average daily volume of 7,000 shares and an AUM of $15,4 million. It has an expense ratio of 0.95 percent and an expense ratio of 0.95 percent.

5. ProShares UltraPro Short QQQ (SQQQ) – Up to 36.5%

ProShares UltraPro Short QQQ gives investors three times the opposite of the daily performance of the Nasdaq-100 Index for an annual fee of 95 basis points. 

Based on market capitalization, the index tracks the performance of the 100 largest non-financial companies listed on The Nasdaq Stock Market that are not banks.

ProShares UltraPro Short QQQ has an AUM of $3.1 billion and trades about 90.2 million shares on average every day.

Why can't leveraged ETFs work for longer?

Leveraged and inverse ETFs use a wide range of investment strategies, such as swaps, futures, and other derivatives, as well as possible long or short positions in securities, to get the expected returns.

Since geared ETFs are only meant to reach the stated leveraged or inverse goal daily, their underlying financial instruments are not set up to do anything other than reach that goal. It's just not what they want to do. 

Returns are often very different from the performance (or the opposite of the version) of their benchmark over a more extended period than stated. This makes these products risky to hold for a long time, especially in markets that change a lot. 

Even though these ETFs can be held for periods that don't match their stated goal. Thus, the position should usually be closely watched. It should be by investors who know what the products are available for and how they cost the longer-term holder by changing the performance over time.

When the underlying instruments are reset every day, it costs the fund manager a lot of money, much more than with a simple 1x ETF. 

Also, most of the underlying instruments' value decreases as the expiration date gets closer. This loss is considered in the daily mix, but investors feel it over a more extended time.

Related questions - FAQs

1. Are ETFs that use leverage a good idea?

Leveraged ETFs use borrowed money, futures, and swaps to magnify the movement of the underlying benchmark. These instruments are best for betting in the short term. Leveraged ETFs aren't a good choice for long-term investors who want a portfolio with a wide range of investments.

2. Can you lose all of your money in leveraged ETFs?

Leveraged ETFs boost daily returns and can help traders make big profits and protect themselves from possible losses. The increased daily returns of a leveraged ETF can cause steep losses in a short time, and the ETF can lose most or all of its value.

3. Should you invest in leveraged ETFs?

Leveraged and inverse ETFs work well for day traders but don't work well in the volatile market because of compounding and tracking error. They are not good things to buy and keep.

4. What is the downside of leveraged ETFs?

One problem with leveraged ETFs is that the portfolio must be constantly rebalanced, which costs more. Instead of using leveraged ETFs, experienced investors who are good at managing their portfolios should control their index exposure and leverage ratio directly.

5. Can leverage ETFs go to zero?

You can expect 2x leveraged ETFs based on high-volatility indexes to go to zero. However, if the market is stable, these ETFs should avoid the same fate as their more highly leveraged counterparts.

Bottom line

The leveraged ETFs strategy is perfect for short-term traders. However, compared to traditional funds, it could lead to considerable losses in markets that are volatile or "seesawing." Due to the emerging effect of compounding, their performance could be very different from that of their underlying index over a more extended time than over a shorter time (like a few weeks or months).