Leveraged ETFs: How Innovation Meets Its Limits

The Rise of Leverage in ETFs

Leveraged ETFs have become a well-established part of today’s ETF ecosystem. Once viewed as niche trading tools, they’ve steadily gained popularity among both retail and institutional traders. These funds are designed to provide magnified single-day exposure—typically two times or three times the daily return of an index or asset class.

Used properly, leveraged ETFs can serve a clear purpose: tactical positioning, short-term hedging, or amplified directional exposure. But even after more than a decade since their inception, many investors still underestimate the risks associated with these products. Some lessons have been learned, others re-learned—and a few are still waiting to be learned the hard way.

Early Days: Direxion and the Birth of Daily Leverage

Leveraged ETFs first gained attention through issuers like Direxion and ProShares, which introduced products offering 2× and 3× daily exposure to benchmarks such as the S&P 500, Nasdaq 100, and various commodity- or mining-related indices.

These funds opened new possibilities—allowing investors to express conviction without using traditional margin directly. But with innovation came complexity. Leveraged ETFs reset daily, meaning their returns over time can deviate significantly from the index they track, particularly during volatile periods.

A Lesson from Gold Miners: When Volatility Meets Leverage

One of the clearest early lessons about the limits of leverage came during a sharp sell-off in the gold-mining sector—an event I remember well from my time at VanEck, where I was directly involved in the ETF capital-markets process.

At the time, the VanEck Gold Miners ETF (GDX) and VanEck Junior Gold Miners ETF (GDXJ)—two of the most widely traded gold-mining funds—experienced significant selling pressure. Several leveraged products tied to these indices, including triple-leveraged miner ETFs from outside issuers, were also being heavily traded.

On paper, those leveraged ETFs were performing as designed—targeting roughly three times the daily inverse or positive move of the underlying basket. But under the surface, liquidity frictions were emerging.

Two structural factors combined to create real-time dislocations:

• Foreign components: Both GDX and GDXJ hold mining companies listed in markets such as Australia and Hong Kong, which were closed during U.S. trading hours. Those foreign single-stock exposures were less liquid and couldn’t be hedged in real time.
• Short-sale restrictions: The NYSE short-sale rule limited market makers’ ability to short those same stocks on a downtick, preventing them from efficiently hedging ETF sales during the drawdown

The combination created a perfect storm. As investors sold GDX, GDXJ, and the leveraged miner ETFs during the sell-off, market makers struggled to short or source the underlying names, causing the ETFs to trade at significant discounts to their NAV or iNAV. The leveraged versions suffered even more because their daily rebalance was based on distorted intraday prices rather than true underlying value.

By the following session, exposures were off, hedges were mismatched, and the leveraged ETFs’ returns diverged well beyond their stated multiples. It was a vivid reminder that leverage magnifies not only return potential but also every friction in market structure—from international trading hours to regulatory mechanics.

In the aftermath, issuers such as Direxion chose to reduce leverage on certain products from 3× to 2×, particularly in volatile sectors like mining, where cross-market liquidity and hedging limits can quickly compound risk.

When Size Becomes a Challenge: Scaling Leverage and Swap Exposure

As leveraged ETFs grew in popularity, so did the complexity of maintaining exposure. What many investors don’t see is that as these products scale, the required swap and derivatives exposure increases proportionally. For large funds, that can mean sourcing billions in daily notional exposure—an increasingly difficult task during market stress.

This dynamic was on full display with the T-REX 2× Long MSTR Daily Target ETF (MSTU). As the underlying stock MSTR (MicroStrategy Inc.) surged with the Bitcoin rally, the ETF’s assets swelled and rebalancing became harder to execute.

Public-filing data and fund disclosures confirm that MSTU seeks 2× the daily return of MSTR. On one day when MSTR posted a nearly 10 percent gain, MSTU rose only about 14 percent—falling short of the intended 2× multiple. [5]

The shortfall wasn’t a management error but rather a structural constraint. To achieve leverage, the fund relies on total-return swaps and options. When volatility spikes, dealers may pull back on providing incremental exposure, forcing managers to rely on less precise instruments, creating tracking error and hedge mismatch.

At scale, leverage becomes a delicate balancing act. The mechanics that work smoothly in a $50 million fund can strain capital-markets plumbing at $5 billion. Leverage magnifies opportunity—but also operational stress.

Case Study: XIV – When the Hedge Unravels

A stark reminder of how leverage and derivatives can collide came in February 2018, when the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) collapsed virtually overnight. The product was designed to provide the inverse of the daily return of VIX futures—essentially shorting volatility.

When volatility spiked during the February 5, 2018 sell-off, the note’s hedging mechanics broke down. XIV fell more than 90 percent in a single session, triggering an automatic termination by its issuer, Credit Suisse, the following day. [6]

Although XIV was technically an ETN rather than an ETF, the event echoed the same risks that can surface in leveraged funds when their derivative exposure outpaces liquidity. The problem wasn’t investor error—it was structural stress: the model worked until the volatility environment made the hedge mathematically impossible to maintain.

The collapse underscored a broader truth across all leveraged and inverse products: when hedging capacity vanishes, leverage can unwind far faster than anyone expects.

Modern Safeguards and the Maturing of the Market

Over the years, leveraged-ETF issuers have become more disciplined. Following the market stress of 2020, the Securities and Exchange Commission (SEC) adopted Rule 18f-4, which established a comprehensive framework governing the use of derivatives by registered investment companies. [1]

Under this rule:

Funds that use derivatives beyond limited thresholds must adopt a Derivatives Risk Management Program (DRMP). This program includes written policies and procedures, stress-testing, back-testing, internal reporting, escalation protocols, and periodic review to ensure that derivatives exposures remain within risk tolerances. [2]

• Each fund must designate a Derivatives Risk Manager (DRM)—a qualified officer who administers the DRMP, is independent of portfolio management, and reports directly to the board of directors on program operation and any material breaches. [3]
• Funds must also comply with value-at-risk (VaR) limits to quantify and control leverage risk. The rule allows for a relative VaR test, typically capped at 200 percent of a designated reference portfolio’s VaR, or an absolute VaR test, generally capped at 20 percent of the fund’s net assets when no appropriate reference portfolio exists. [4]
• Certain pre-existing leveraged and inverse funds received a limited grandfathering exemption from these VaR thresholds, provided they maintain enhanced risk disclosures and board oversight. [5]

Beyond regulatory minimums, many issuers have developed internal best practices that further strengthen oversight and operational resilience. These include:

• Engaging multiple swap counterparties to diversify exposure and reduce reliance on any single prime broker.
• Implementing intraday rebalancing flexibility to adjust exposures during sharp market moves.
• Maintaining tighter internal exposure and margin thresholds, dynamic hedging frameworks, and continuous monitoring of hedge-capacity stress.

While these enhancements are not explicitly mandated by Rule 18f-4, they represent a collective evolution in how issuers manage derivative-related leverage—creating a more stable and transparent environment for investors.

Learning from the Past — and Hoping Not to Repeat It

After years of observing how these products behave in calm and chaotic markets, established issuers have made wise and necessary adjustments. Reducing leverage wasn’t just a business move—it was a protective measure for investors and for the ETF ecosystem itself.

By scaling back from 3× to 2× in certain funds, firms like Direxion and ProShares reduced the risk of structural breakdowns and helped prevent single-day volatility from cascading into broader market inefficiency. Those decisions were driven by experience—by lessons learned the hard way.

Unfortunately, not everyone seems to remember those lessons. New entrants continue to push the limits, re-introducing products that feel reminiscent of the early days of leveraged innovation. Some seem eager to test the boundaries again, assuming “this time is different.”

The truth is, the mechanics of leverage are unforgiving. When volatility spikes, hedging capacity evaporates, and market rules interact in unexpected ways, the outcome can be swift and painful. Let’s hope we don’t see too many repeat performances.

And as a side note—I’m almost surprised we haven’t seen a double-leveraged silver-miners ETF yet. Then again, with the miners down over ten percent today, maybe that’s not such a bad thing.

Closing Thought

Leveraged ETFs represent both the power and fragility of market innovation. They give investors precise, tactical tools—but demand respect for their mechanics. Each generation of products teaches us something new, often by reminding us of what we already should have known.

If there’s one consistent truth in the ETF world, it’s that leverage always finds the limits of liquidity first. Understanding those limits—and respecting them—is what separates a useful trading tool from a dangerous one.

Footnotes

1. U.S. Securities and Exchange Commission, Final Rule: Use of Derivatives by Registered Investment Companies and Business Development Companies (Release IC-34084), Nov 2020.

2. SEC, Small-Entity Compliance Guide for Rule 18f-4, updated 2022.

3. Ropes & Gray LLP, SEC Adopts Rule 18f-4 Concerning Registered Funds’ Use of Derivatives, Nov 2020.

4. Skadden, SEC Adopts Rules for Use of Derivatives by Registered Investment Companies, Nov 2020.

5. ACA Global, Understanding SEC Rule 18f-4 and its Grandfathering Provisions for Leveraged/Inverse Funds, Jan 2021.

6. Morningstar and ETF Database, MSTU Quote and Performance Data.

7. Reuters, Credit Suisse volatility fund liquidated after market sell-off, Feb 6 2018.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.