How do hedge funds use leveraged ETFs?

The growing popularity of ETFs can mostly be attributed to the fact that they provide retail and institutional investors, such as hedge funds, with the increased portfolio diversification that comes with mutual funds (although some focus on specific assets), but with the ability to trade as regular stock on a public exchange.

This is particularly useful for hedge funds looking to increase their exposure to a wider range of assets without going through the more costly and complicated process of selecting and managing their investments.

Leveraged ETFs, on the other hand, are relatively new investment vehicles and can be both more complicated and riskier. Despite this, data from Stock Market MBA shows that leveraged ETFs have gained significant popularity since their introduction to the market.

What are leveraged ETFs?

The first leveraged ETFs were introduced in 2006 by American ETF issuer, ProShares. In essence, leveraged ETFs increase exposure to the underlying assets or indices that make up an ETF and in doing so, amplify the impact the said ETF will have on an investment. This means that a leveraged ETF could aim to double, or triple, the return of an index on a daily basis. The ProShares Ultra Dow 30 ETF (DDM), for example, has been engineered to give a 2% return when the Dow Jones Industrial Average gains 1% – though of course, past performance of any investment vehicle is not necessarily indicative of future performance.

As the process for investing in an ETF is as simple as executing a buy order through a trading platform, it’s much simpler for institutional investors to access leverage through the use of leveraged ETFs than using options, futures or trading on margin.

While leveraged ETFs can provide investors with increased returns, it should be noted that there’s also a risk of increased losses if the underlying index or assets making up an ETF drop in value. What’s more, leveraged ETFs are often more expensive than standard ETFs, as the expense ratios, taxes and turnover costs are often higher.

How hedge funds trade leveraged ETFs

There are two ways in which hedge funds are most likely to use leveraged ETFs to their advantage. Firstly, leverage can be a great way for investors to gain overexposure to an index or specific sector by opening a position for a fraction of the cost.

For example, if a hedge fund wishes to diversify its portfolio by increasing its exposure to semiconductors, but is limited by how much capital it has available, it could invest in a leveraged ETF. In doing so, the hedge fund would effectively increase its portfolio’s exposure to the semiconductor market without needing the same amount of capital it would if it were to invest in a standard ETF.

The second way hedge funds use leveraged ETFs is to capitalise on the daily price movements of a market, index or specific sector. However, to avoid adverse compounding effects, most will buy and sell their shares in a leveraged ETF during the same trading day.

The risks of leveraged ETFs

It’s much easier for a hedge fund to optimise its trading strategy and make more informed buy and sell decisions when it’s fully aware of the risks it’s taking to maximise returns. Below we discuss some of the risks that hedge funds should be aware of when dealing with leveraged ETFs.

As previously mentioned, one risk is that of compounding, which can make a leveraged ETF lose a lot of, or even all of, its value over a long period of time. This is partly because leveraged ETFs use derivatives to track the underlying asset or index. While this can mirror daily returns with minimal tracking error, derivatives are less accurate when it comes to long-term investments.

However, as the whole point of using leveraged ETFs is to generate weighty returns and hedge against potential loss, experienced hedge funds and traders shouldn’t be deterred, provided they have a clear trading strategy.

Another issue that hedge funds should be aware of is that not all leveraged ETFs have high trading volumes, which could restrict a hedge fund’s ability to buy or sell shares. For this reason, hedge funds should always check the volume of the leveraged ETF they’re considering investing in before opening a position.

To summarise, although there are risks attached to leveraged ETFs, when used carefully they can prove to be an effective investment vehicle for both diversifying a hedge fund’s portfolio and generating optimal returns.