What are Leveraged ETFs and how do they work?

What are leveraged ETFs?

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 FTSE 100 will contain the 100 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 buy listed futures and options or trade with OTC products like CFDs to increase the 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. 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 FTSE 100 UCITS ETF, an extremely common FTSE 100 index tracker. As explained earlier, the ETF contains the 100 stocks in the FTSE – 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 FTSE 100 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 mirror underlying assets with few errors

Cons of leveraged ETFs

• Leveraged ETFs are not 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

1. Learn more about leveraged ETFs
2. Open an account with us or practise on a demo
3. Select your opportunity
4. Choose your position size and manage your risk
5. Place your deal and monitor your trade

It's important to note that leveraged ETFs are rarely recommended for a long investing period. They are usually only used as part of a short-term trading strategy. The opposite is true of standard non-leveraged ETFs.

It's also worth noting that if you trade leveraged ETFs with CFDs, you'll effectively be trading with leverage on top of leverage. This can be very volatile, so it may be worth trying out the strategy with our demo account first to get an idea of the risks involved.

Leverage, as mentioned, is risky because it magnifies the profit or loss you could realise. If you trade with CFDs, you could gain or lose money rapidly, and could lose more than your initial deposit.

Leveraged ETFs vs trading ETFs

As previously explained, 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 is an alternative option: to trade standard non-leveraged ETFs but utilise leverage as you would any other asset. This leverage is often lower and presents the opportunity to better control risk and experiment with the psychology and returns of leverage in real trading.

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 pays to be extremely careful when placing trades.

1. ProShares Ultra S&P500 – 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&P500 – 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 – 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 – 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

Essentially, there is a leveraged ETF to suit almost all tastes.

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 will not closely mirror the returns of the index the ETF tracks
• Leveraged ETFs are often used by short-term traders to maximise returns

Sources

1. Leveraged ETFs: What They Are & How They Work – Seeking Alpha
2. What Is a Leveraged ETF? – Motley Fool
3. 8 Best Leveraged ETFs Of 2023 – Forbes