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

What Is a Leveraged ETF?

A leveraged exchange-traded fund (ETF) is a marketable security that uses financial derivatives and debt to amplify the returns of an underlying index. While a traditional exchange-traded fund typically tracks the securities in its underlying index on a one-to-one basis, a leveraged ETF may aim for a 2:1 or 3:1 ratio.

Leveraged ETFs are available for most indexes, such as the Nasdaq 100 Index and the Dow Jones Industrial Average (DJIA).

Leveraged ETFs Explained

ETFs are funds that contain a basket of securities that are from the index that they track. For example, ETFs that track the S&P 500 Index will contain the 500 stocks in the S&P. Typically, if the S&P moves 1%, the ETF will also move by 1%.

A leveraged ETF that tracks the S&P might 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 is contingent on the amount of leverage used in the ETF. Leveraging is an investing strategy that uses borrowed funds to buy options and futures to increase the impact of price movements.

However, leverage can work in the opposite direction as well and lead to losses for investors. If the underlying index falls by 1%, the loss is magnified by the leverage. Leverage is a double-edged sword meaning it can lead to significant gains, but it can also lead to significant losses. Investors should be aware of the risks of leveraged ETFs since the risk of losses is far higher than those from traditional investments.

The management fees and transaction costs associated with leveraged ETFs can diminish the fund's return.

The Leverage in Leveraged ETFs

A leveraged ETF might use derivatives—such as options contracts—to magnify the exposure to a particular index. It does not amplify the annual returns of an index but instead tracks the daily changes. Options contracts grant an investor ability to trade an underlying asset without the obligation that they must buy or sell the security. Options contracts have an expiration date by which any action must be completed.

Options have upfront fees—known as premiums—associated with them and allow investors to buy a large number of shares of a security. As a result, options layered with investment, such as stocks, can add to the gains of holding the stock investment. In this way, leveraged ETFs use options to add to the gains of traditional ETFs. Portfolio managers can also borrow to buy additional shares of securities, further adding to their positions but also adding to the potential for gains.

A leveraged inverse ETF uses 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 can be other costs involved with leveraged exchange-traded funds. Leveraged ETFs have higher fees than non-leveraged ETFs because premiums need to be paid to buy the options contracts as well as the cost of borrowing—or margining. Many leveraged ETFs have expense ratios of 1% or more.

Despite the high expense ratios associated with leveraged ETFs, these funds 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 purchase stocks or other 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. The use of 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 lose value.

Leveraged ETFs as Short-term Investments

Leveraged ETFs are typically used by traders who wish to speculate on an index, or to take advantage of the index's short-term momentum. Due to the high-risk, high-cost structure of leveraged ETFs, they are rarely used as long-term investments.

For example, options contracts have expiration dates and are usually traded in the short term. It is difficult to hold long-term investments in leveraged ETFs because the derivatives used to create the leverage are not long-term investments. As a result, traders often hold positions in leveraged ETFs for just a few days or less. If leveraged ETFs are held for long periods, the returns may be quite different from the underlying index.

Real World Example of a Leveraged ETF

The Direxion Daily Financial Bull 3x Shares (FAS) ETF holds equities of large U.S. financial companies by tracking the Financial Select Sector Index. It has an expense ratio of 0.96% and top holdings include Berkshire Hathaway (BRK.B), Visa (V) and JP Morgan Chase (JPM). The ETF aims to provide investors 3xs the return for the financial stocks it tracks.

If an investor, for example, invested $10,000 in the ETF and the stocks tracked from the index rose by 1%, the ETF would return 3% in that period. However, if the underlying index declined by 2%, the FAS would have a loss of 6% for that period.

As stated earlier, leveraged ETFs are used for short-term moves in the market and can result in large gains or losses very quickly for investors.