To buy stocks with leverage in the past, you needed a margin account with your broker. Trading on margin is essentially the same as taking out a line of credit with your broker. You can only borrow a certain amount, and you must pay interest on the money you borrow from your broker. Another restriction is that stock purchases on margin are not permitted in IRA accounts.
Because you can simply buy a leveraged ETF and there are leveraged ETFs that track many kinds of markets, ETFs offer a drastically new method to invest with leverage.
Leveraged ETFs are ETFs that track an index, but they try to go up or down twice or three times the amount that the actual index goes up or down every day using intricate trading strategies and derivatives. If the index they’re tracking increases by 1% on a given day, a leveraged 2x ETF tracking the same index will increase by 2%. Alternatively, if the index falls 1% on a particular day, the leveraged 2x ETF tracking the same index will fall 2%.
SSO has a 0.009000 expense ratio and a 3,318,599 share average trading volume. Margin interest rates range from 2% to 7% in today’s low-interest climate, depending on your broker and the amount you’re borrowing. As a result, utilizing a leveraged ETF like SSO to leverage your investing portfolio is theoretically a cheaper option.
There are now 214 leveraged ETFs available.
The total average daily trading volume of these leveraged ETFs is 594,145,919 shares, which gives you an idea of how popular they are.
If you’re interested, you may look over the entire list of leveraged ETFs. Just looking at the list may give you a better idea of the variety of leveraged ETFs available today.
How do they do it?
To gain the appropriate exposure to the index, a leveraged ETF often buys and sells derivative items, such as futures contracts and swap agreements. These derivatives are contracts that allow you to obtain exposure to specific indices and sectors without having to invest in them dollar for dollar. The leveraged ETF often has private swap arrangements with large international investment banks such as UBS, Credit Suisse, Morgan Stanley, and Goldman Sachs. Some ETF sponsors make their swap agreements with third parties public on their websites, while others do not (those ETF sponsors merely list “S&P 500 index swap” as a holding, without mentioning the investment bank that it is with).
In addition to derivatives, most leveraged long ETFs own individual assets that are relevant to the index they monitor, or shares in a non-leveraged ETF that tracks the same index. TNA, the Direxion Daily Small Cap Bull 3x Shares ETF, for example, often holds shares of IWM, the iShares Russell 2000 ETF, a non-leveraged ETF that replicates TNA’s index. In most cases, leveraged inverse ETFs only own derivatives.
Leveraged ETFs usually have a large amount of cash and short-term securities on hand as well.
This is partly due to the fact that they don’t need all of their available cash to buy the essential derivatives, and they’re usually required to keep some cash on hand to meet swap agreement reserve requirements.
It’s frequently difficult to understand why many long leveraged ETFs own the securities they do vs the cash and short-term securities they have on hand.
TNA, for example, has a market valuation of almost $700 million but only owns a small portion of that in IWM. Every day, running a leveraged ETF necessitates a complex set of computations to ensure that the ETF has the appropriate leveraged exposure to the index, resulting in a confusing mix of cash, securities, and derivatives.
Leveraged ETFs Have A Hard Time Tracking Their Index
Despite the fact that leveraged ETFs are quite excellent at matching the index’s outcomes on any particular day, they cannot and do not track the index’s results over longer periods of time. Leveraged ETFs disclose in their disclosures that they can’t match the performance of an index over longer periods of time; their primary purpose is to track the index’s results on a daily basis.
On a daily basis, most leveraged ETFs rebalance or reset their leverage.
What exactly does that imply?
Every day, the leveraged ETF must modify its balance sheet — a complicated combination of derivatives, securities, and cash on hand — to maintain 2x or 3x index exposure.
This isn’t going to be easy. Assume that a leveraged 3x ETF has a $100,000,000 exposure to the S&P 500 Index on day one. If the S&P 500 index rises 1.2 percent the next day, the leveraged 3x ETF must determine which combination of cash, securities, and derivatives must be purchased or sold such that the leveraged 3x ETF maintains the appropriate 3x exposure to the index by tomorrow.
Understanding the impact of daily compounding on a leveraged ETF is critical. The mathematics behind why a leveraged ETF’s “daily compounding” and “daily re-setting” affects its performance over time can be intricate. However, the cumulative effect of daily compounding might be enormous. According to FINRA Notice 09-31,
Without going through some arithmetic examples, it’s difficult to illustrate the impact of daily compounding on a leveraged ETF.
Consider a highly volatile asset that goes up 5% one day and then drops 4% the next. The price of a perfect double leveraged ETF that tracks the identical asset rises 10% on the first day and falls 8% on the second. The underlying asset gained at the end of the second day. 8% of the population
This is standard behavior because the fund’s assets are rebalanced every day to meet the daily target.
Consider an asset that has risen 10% in two days. The asset has increased by 21% on the second day:
Now that you’ve grasped the arithmetic, here’s a quick rundown of how everyday compounding affects the performance of a leveraged ETF over time:
- A leveraged 3x ETF (or 2x ETF) will actually return more than 3x (2x) the results of the underlying index in a strongly trended upward bull market.
- A leveraged 3x ETF will fall far more than 3x the outcomes of the underlying index in a strongly trended bear market.
- Even if the market ends up with a little gain, a leveraged 3x ETF’s results will tend to lose tracking of the index and will likely lose money in a volatile market with plenty of ups and downs.
The ETF SPY (which tracks the S&P 500 Index) increased by 9.7% from December 24, 2012 to March 28, 2013, yet the leveraged 3x ETF UPRO (which also tracks the S&P 500 Index) increased by 31.5 percent.
The ETF EEM (which tracks the MSCI Emerging Markets Stock Index) fell 1.1 percent between December 24, 2012 and March 28, 2013, while the leveraged 3x ETF EDC (which also tracks the MSCI Emerging Markets Stock Index) fell 5.5 percent.
Another way to illustrate this effect is to look at a chart of one of our ratio symbols, UPRO:SPY, which is just the market price of UPRO divided by the market price of SPY:
As you can see, UPRO:SPY rises during strong bull markets, such as those seen in 2013 and 2014 – i.e., when SPY rises sharply, UPRO rises even faster, thanks to daily compounding.
However, with the downturn in SPY in October and November 2012, UPRO:SPY also fell, implying that UPRO performed worse than 3x SPY.
UPRO is a 3x leveraged exchange-traded fund.
The challenge is similar with a 2x leveraged ETF that resets everyday, but it’s not as severe.
Take, for example, SSO, a 2x ETF that tracks the S&P 500:
The same pattern may be seen on both sides. In a robust bull market, SSO can outperform SPY by more than double. During a severe downturn, SSO can do even worse than SPY. So be cautious!
Why Do Leveraged ETFs Have Dividends?
The dividends paid by a leveraged ETF are not based on the dividends paid by the underlying index it is attempting to mirror (there is a special class of leveraged ETNs that do pay dividends based on the underlying dividends – seeread more about leveraged high dividend ETNs). Nonetheless, a large number of leveraged ETFs, particularly leveraged inverse ETFs, pay dividends. And the dividends can be enormous, even though they are difficult to anticipate and vary significantly from one period to the next.
Dividends can be paid by a leveraged ETF for two reasons.
Leveraged ETFs, as previously stated, use derivatives to provide the fund with the appropriate exposure to an index or benchmark while not depleting the fund’s cash.
As a result, the leveraged ETF has capital to invest in debt securities and/or money market instruments that earn current interest rates.
This short-term net investment revenue must be distributed to the company’s stockholders. Alternatively, the fund may produce short-term financial gains while buying and selling futures contracts and/or swap agreements, which must be distributed to shareholders. IRS regulations require all Investment Company Act of 1940 ETFs to distribute substantially all of their net investment income and capital gains to shareholders at least once a year.
All of the information is based on a real-time query from our database. The text was last changed on December 21, 2017.
Can you lose your entire investment in a leveraged ETF?
A: No, while using leveraged funds, you can never lose more than your initial investment. Buying on leverage or selling stocks short, on the other hand, can result in investors losing significantly more than their initial investment.
What are the drawbacks of leveraged ETFs?
Leveraged ETFs can help traders produce outsized returns and safeguard against potential losses by amplifying daily returns. The exaggerated daily returns of a leveraged ETF can result in large losses in a short period of time, and a leveraged ETF can lose much or all of its value.
How do leveraged ETFs generate revenue?
To magnify exposure to a specific index, a leveraged ETF could use derivatives like options contracts. It does not enhance an index’s annual returns, but rather tracks daily fluctuations. Options contracts allow an investor to trade an underlying asset without having to acquire or sell it. Any action taken under an option contract must be completed before the expiration date.
Options are coupled with upfront payments (known as premiums) and allow investors to purchase a large number of shares of a security. As a result, options layered with a stock investment might increase the gains from holding the shares. Leveraged ETFs employ options to supplement the gains of standard ETFs in this way. Portfolio managers can also borrow money to buy more securities, increasing their positions while also increasing their profit potential.
When the underlying index falls in value, a leveraged inverse ETF employs leverage to earn money. To put it another way, an inverse ETF increases as the underlying index falls, allowing investors to profit from a negative market or market losses.
Do all leveraged ETFs end up at zero?
Even when the underlying index performs well, leveraged ETFs can perform poorly over longer time periods. The geometric nature of returns compounding and ill-timed rebalancing are to blame for the longer-term underperformance. The author shows that highly leveraged ETFs (3x and inverse ETFs) are likely to converge to zero over longer time horizons using the concept of a growth-optimized portfolio. 2x leveraged ETFs can similarly be predicted to decay to zero if they are based on high-volatility indexes; however, in moderate market conditions, these ETFs should avoid the fate of their more heavily leveraged counterparts. The author proposes that an adaptive leverage ETF might produce more appealing results over longer time horizons based on these concepts.
Are leveraged ETFs a suitable long-term investment?
The response is a categorical NO. Leveraged exchange-traded funds (ETFs) are designed for short-term trading. Long-term holding of a leveraged ETF can be extremely risky due to a phenomena known as volatility decay.
Vanguard offers leveraged ETFs.
Vanguard discontinued accepting purchases of leveraged or inverse mutual funds, ETFs (exchange-traded funds), and ETNs on January 22, 2019. (exchange-traded notes). If you currently own these investments, you have the option of keeping them or selling them.
Is 3x leverage a good idea?
- ETFs that are triple-leveraged (3x) carry a high level of risk and are not suitable for long-term investing.
- During volatile markets, such as U.S. equities in the first half of 2020, compounding can result in substantial losses for 3x ETFs.
- Derivatives are used to provide leverage to 3x ETFs, which introduces a new set of risks.
- Because they have a predetermined degree of leverage, 3x ETFs will eventually collapse if the underlying index falls by more than 33% in a single day.
- Even if none of these potential calamities materialize, 3x ETFs have substantial fees, which can result in considerable losses over time.
Why should you avoid holding leveraged ETFs for a long time?
- Leveraged exchange-traded funds (ETFs) are meant to provide higher returns than traditional exchange-traded funds.
- One downside of leveraged ETFs is that the portfolio must be rebalanced on a regular basis, which incurs additional fees.
- Instead of using leveraged ETFs, experienced investors who are comfortable managing their portfolios should handle their index exposure and leverage ratio manually.
Do leveraged exchange-traded funds (ETFs) outperform the market?
Leveraged ETFs will outperform the index despite volatility decay if volatility is modest, leverage is not excessive, and markets increase swiftly. Due to volatility decay, leveraged ETFs will not outperform the index if volatility is strong, leverage is too great, or markets increase slowly.
What are 3X leveraged exchange-traded funds (ETFs)?
Leveraged 3X ETFs monitor a wide range of asset classes, including stocks, bonds, and commodity futures, and use leverage to achieve three times the daily or monthly return of the underlying index. These ETFs are available in both long and short versions.
More information on Leveraged 3X ETFs can be found by clicking on the tabs below, which include historical performance, dividends, holdings, expense ratios, technical indicators, analyst reports, and more. Select an option by clicking on it.