Leveraged ETFs: what are they and how do they work?

What is a leveraged ETF?

To start with, it's important to understand that an exchange-traded fund (ETF) is a fund that contains a basket of securities from the index that it tracks. An ETF that tracks the ASX 200 will contain the 200 stocks in the index, weighted so that when the index moves up or down, the ETF mimics its performance as closely as possible.

Then, there's the concept of leverage – an investing strategy that uses borrowed funds (debt) to trade using financial derivatives CFDs to increase the possible financial returns of price movements.

A leveraged ETF, therefore, is an exchange-traded fund that holds debt and shareholder equity. It uses the debt to amplify potential shareholder returns or losses. Non-leveraged ETFs, on the other hand, only hold shareholder equity. These simply track an underlying asset class or index.

Fund managers in charge of a leveraged ETF aim to generate daily returns that are multiples of the performance of the underlying index or asset. Here, the primary aim is to deliver returns that exceed the cost of the assumed debt. They usually do this using derivatives contracts – such as futures and options – to further amplify returns. Some managers even use derivatives to generate returns if the index or asset class falls in value, for investors who believe an asset is due to fall.¹

An important consideration is that leverage is a double-edged sword – any losses are correspondingly magnified. Investors should consider leveraged ETFs with their eyes wide open. Losses can be far higher than with traditional investments, while standard index-linked ETFs have a reputation for safety.

There are usually transaction costs and management fees to pay too, which can reduce a fund's return. An expense ratio of circa 1% is about average, though fees can be far higher for select ETFs.

How do leveraged ETFs work?

Consider the iShares Core S&P/ASX 200 ETF, popular ASX 200 index tracker. As explained earlier, the ETF contains the 200 stocks in the ASX – such that if the index rises or falls by 1%, the ETF will also rise or fall by 1%. In contrast, a leveraged ETF that tracks the ASX 200 would usually use debt to magnify this 1% movement to deliver returns of 2%, 3% or even higher.

Imagine a scenario where you hold shares in a triple-leveraged ETF that tracks the price of the largest lithium stocks. One day, a huge advance in nickel-based EV batteries renders lithium-ion EV batteries outdated. Demand for lithium is predicted to plummet, and lithium stocks lose an average of 20% of their value within a few hours. The value of your shares in the triple-leveraged ETF would fall by 60%.

Even worse, the lithium stocks would need to rise by 25% in a non-leveraged ETF to recoup the losses. With a triple-leveraged ETF, the stocks would need to rise by 150% to recover from the loss.

On the other hand, this does allow for greater profit – if you predict price movements correctly.

Pros and cons of leveraged ETFs

Leveraged ETFs are often used by short-term traders to maximise returns. For example, consider a trader who expects the price of gold to increase over the course of the trading day – exposure to leverage means they can generate higher returns if they are correct. Of course, if they are incorrect, leverage also amplifies the losses.

This means that investors buying shares in leveraged ETFs usually have a strong conviction that they are right – though this doesn't necessarily mean that they are.

Pros of leveraged ETFs

• Traders have a huge range of assets to trade using leveraged ETFs, as they are traded in the open market
• Leveraged ETFs offer traders the chance to generate significant returns that exceed an underlying index or basket of securities
• Traders can make money when the market is declining using inverse leveraged ETFs
• Traders can also use leveraged ETFs to hedge against potential losses
• Investing in a leveraged ETF often confers indirect exposure to futures and options contracts
• Like standard ETFs, leveraged ETFs attemp to mirror underlying assets

Cons of leveraged ETFs

• Leveraged ETFs aren't generally long-term investments, and over time, an investment will not closely mirror the returns of the index that the ETF tracks
• Leveraged ETFs have higher fees and expense ratios compared to non-leveraged ETFs
• Leveraged ETFs can generate significant losses that exceed the underlying index
• Magnified losses take far longer to recover from, a recovery may not happen, and losses can occur very quickly
• Some specialised leveraged ETFs are low volume, making buying or selling shares harder, especially when a trade is going against you

How to trade or invest in leveraged ETFs

How to invest in leveraged ETFs through share trading

1. Create an account or log in
2. Learn more about leveraged ETFs
3. Search for the leveraged ETF you'd like to invest in
4. Select 'buy' in the deal ticket (you can only go long when investing)
5. Choose the number of shares you want to buy
6. Open and monitor your position

How to trade on leveraged ETFs with CFDs

1. Create an account or log in
2. Learn more about leveraged ETFs
3. Choose CFDs and search for your opportunity
4. Select 'buy' to go long or 'sell' to go short
5. Set your position size and take steps to manage your risk
6. Open and monitor your position

With share trading, you own the shares outright. You profit if the share rises in price or if it pays out dividends.

With CFD trading, you speculate on price movements rather than own the shares yourself. This instrument is leveraged, so you could gain or lose money quickly – including the potential to lose more than your deposit. You could even lose more than your initial deposit to open the position as potential profits and losses are magnified to the full value of the trade. It's useful to keep in mind when you're making your trades that past performance isn't a guarantee of future patterns.

Before you invest in an ETF, it's important to consider the relevant Target Market Determination available from the ETF issuer to detemine whether the ETF is consistent with your objectives, financial situation and needs.

Learn more about the differences between trading and investing

New to investing or trading? Practise on a demo account to build your confidence.

Buying leveraged ETFs vs trading standard ETFs

As explained previously, when you invest by buying shares in a leveraged ETF, you gain magnified exposure to the underlying asset through leverage. This increases both the risks and the rewards of the investment.

However, there's an alternative option: to trade standard, non-leveraged ETFs but utilise leverage as you would any other asset.

Examples of leveraged ETFs

There are hundreds of leveraged and inverse leveraged ETFs to consider. However, the following are some of the most popular, as they follow common indices or assets. As a caveat, many leveraged ETFs have similar names, so it's important to be very careful when placing trades.

1. ProShares Ultra S&P 500 ETF – a leveraged ETF designed to return twice the daily return of the S&P 500. If the S&P 500 rises by 5%, then the ETF would rise by 10%, conversely, if the index fell by 5%, then the ETF would fall by 10%²
2. ProShares UltraShort S&P 500 ETF – an inverse leveraged ETF designed to return twice the opposite of the S&P 500's daily movement. If the S&P 500 falls by 5%, then the ETF rises by 10%. And if the index rises by 5%, then the ETF falls by 10%
3. ProShares UltraPro Short QQQ ETF – which offers three times the downside exposure to NASDAQ 100-listed tech titans. The ETF consistently boasts an average daily volume of over 100 million shares, making it a popular option
4. ProShares UltraPro Short Dow30 – this ETF offers three times the downside leverage exposure to the Dow Jones Industrial Average index. However, the average daily volume is 'only' 10 million shares, so liquidity can be an issue
5. Direxion Daily Semiconductor Bull 3x Shares – this ETF offers three times the leveraged upside exposure to a pre-selected assortment of companies involved in developing and manufacturing semiconductors. This is a popular non-index ETF, with over 100 million shares traded every day³

There is a leveraged ETF to suit almost all preferences.

Leveraged ETF stocks summed up

• A leveraged ETF is an exchange-traded fund that holds debt and shareholder equity, using the debt to amplify the potential shareholder returns
• Fund managers in charge of a leveraged ETF aim to generate daily returns that are multiples of the performance of the underlying index or asset
• There are usually transaction costs and management fees to pay, which can reduce a fund's return. An expense ratio of circa 1% is about average, though fees can be far higher
• Leveraged ETFs are not long-term investments, and over time the investment won't closely mirror the returns of the index the ETF tracks
• Leveraged ETFs are often used by short-term traders to maximise returns

¹ Seeking Alpha, 2022
² The Motley Fool, 2023
³ Forbes, 2023