Updated July 17, 2023
Definition of Leveraged ETF
A leveraged exchange-traded fund (ETF)refers to a fund that uses debts and financial derivatives to accelerate the number of returns against the underlying benchmark.
A leveraged ETF uses the technique of leveraging, i.e., it deploys the borrowed funds to buy derivative instruments to take maximum advantage of the price movements in the future. They trade at prices that may be higher or lower than their net value depending on the market’s prevailing prices.
Some investors have ample funds and want to speculate about forecasting the direction of the prices of an asset and earning huge profits from such speculations. A leveraged exchange-traded fund (ETF) is such a fund that uses borrowed funds to invest in derivative instruments such as options and futures in the underlying securities as that of its benchmark index so that the returns that are generated on such an ETF get magnified as compared to the returns of its benchmark index. However, the leverage technique, if fails, can also multiply the investor’s losses. Unlike a regular ETF, which can only track the securities in its underlying index on a 1:1 ratio, a leveraged ETF may aim to multiply the returns for a 2:1 or even 3:1 ratio.
How Does It Work?
Leveraged ETFs are mutual funds that trade in the stock exchanges. The fund might be fully or partially tracking its benchmark index or might be actively managed. Leveraged ETFs try to double or triple the daily performance of the index or asset classes by using debts and financial derivatives. Returns are high in a short-term period due to price fluctuations. Such ETFs attract investors ready to bear the risk and have huge funds to speculate to earn, as the profit in leveraged ETFs is exceptionally high.
Example of Leveraged ETF
Let us assume ‘X’is a leveraged ETF that invests in securities based on tracking its benchmark index is S&P 500. ETF has $1.5 billion in assets; the expense ratio is 3℅ , and aims to achieve 2 times the return of the financial index. The trader holds $5,000 in ETF; when the S&P 500 increases by 1%, the ETF will provide a return of 2℅. Similarly, if the underlying index decreases by 2%, ETF will face a loss of 4% during that period. Here the tracking ratio of the leveraged ETF is 2:1.
Leveraged ETF Risk
There is a high level of risk in the Leveraged ETFs as it not only multiplies the profit but also multiplies the progress of the regular index, which can result in the multiplication of loss if the prices move in the opposite direction against the fund’s strategy. Suppose the tracking ratio is 3:1 for a leveraged ETF, and the price movements are adverse against the initial expectations. In such a case, the ETF will create equivalent losses instead of magnifying the returns by 3 times. As a result, investors can bear an exceptionally high loss in Leveraged ETFs. Thus, such ETFs are suitable for investors with a lot of funds and are not afraid of fluctuations in the investment market.
Importance of Leveraged ETF
It is deemed important due to the following reasons:
- The main importance is that it gives the investor the potential to magnify the investment returns and earn a high-profit level.
- It is profitable for the investors even when the market is declining, as they can profit by using inversely leveraged ETFs.
- The leveraged ETF can be purchased easily, so even a newbie can purchase it, as there are managers to manage it efficiently.
- The opportunity to liquidate the investment is available for the investors.
- The returns generated are higher in the case of a leveraged ETF than in a regular ETF.
Some of the benefits are given below:
- Huge opportunity for returns: ETF gives investors a huge opportunity to earn as their investments can be multiplied here only if they are ready to take risks.
- Earning at the time of market decline: The investors in the leveraged ETF can earn profit even at the time of market decline by using inverse leveraged ETF.
- Potential to earn: It gives its investors a huge potential to earn as their return can be amplified twice or thrice.
Some of the disadvantages are given below:
- High risk: There is a high level of risk in the leveraged ETF as the losses can be multiplied here.
- Expense ratio: Some managers manage the work of investment for which they charge some fees, which increases the expense ratio also.
- Not a long-term investment: It is suitable for investors looking for a short-term horizon, and the investors willing to invest for a long period of time do not find it attractive.
Many risk factors are involved in leveraged ETFs, but for an investor willing to earn profit and ready to bear exaggerated risk, that is not a bar. These are funds for risk lovers. So, one must grab the in-depth knowledge of the path to be traveled as risk is accompanied by profit here depending on the type of investor and preferences.
This is a guide to Leveraged ETF. Here we also discuss the definition and importance along with advantages and disadvantages. You may also have a look at the following articles to learn more –