Leverage ETFs, effective but potentially dangerous

What is a Leveraged ETF?

A Leveraged ETF is a financial security that uses derivatives to amplify the returns of an underlying index. Most traditional ETFs will track the performance of an index as closely as possible. However, a Leveraged ETF may provide 2x or 3x the return of the underlying index.

Leveraged ETFs are available on various indexes such as the S&P 500, Dow Jones Industrial Average, and the NASDAQ 100, among others.

For example, the typical S&P 500 ETF index can increase 2% within a single day, meaning that a traditional S&P 500 ETF will increase by approximately 2%. Therefore, a two-times Leveraged ETF or three-times Leveraged ETF would go up around 4% and 6%, respectively. 

It must be kept in mind that losses are also amplified. A 2% loss could become a 4% loss, and 6% loss with the use of a two-times and three-times Leveraged ETF.

Why use a Leveraged ETF?

Leveraged ETFs have the potential for significant gains in a short amount of time. This is ideal for traders with a strong view on a specific index that they expect to play out shortly. For example, a trader can expect a strong market rally based on an event such as an FOMC meeting or unemployment information release.

Leveraged ETFs also offer a wide variety of securities to trade. Furthermore, Leveraged ETFs can be applied to short-biased ETFs. This means that traders can make significant gains during a market sell-off.

Examples of Short-Biased ETFs

SPXL (Direxion Daily S&P 500 Bull 3X Shares)

• AUM: $1,902M
• Expense Ratio: 0.97%
• YTD performance: -55.4%

TQQQ (ProShares UltraPro QQQ 3X)

• AUM: $9,864M 
• Expense Ratio: 0.95%
• YTD performance: -72.1%

UDOW (ProShares UltraPro Dow30 3X)

• AUM: $527M 
• Expense Ratio: 0.95%
• YTD performance: -43.8%

Risks and Considerations of Leveraged ETFs

Leveraged ETFs should not be used as long-term investments. This is because of the compounding effect of losses— Leveraged ETFs attempt to provide an enhanced daily return. Over long periods, Leveraged ETFs fail to track the return of the benchmark index.

For example, if an index increases by 10% on one day and decreases by 10% on the next day. Therefore, a portfolio of $1,000 would end up at $990.

However, with a 3x Leveraged ETF, the increase would be 30% on one day and would decrease by 30% on the next day. This portfolio of $1,000 would end up at $910.

Using leverage has eroded returns, and this effect becomes more pronounced over more extended periods and with more volatile price movements.

Furthermore, it should also be considered that Leveraged ETFs have higher management expense ratios than traditional ETFs due to the leverage costs and management costs. 

Data for this article is as of June 15th, 2022.