A leveraged exchange-traded fund (LETF) is a security that uses financial derivatives and debt to amplify the returns of an underlying index or other assets it tracks. While traditional ETFs track securities on a one-to-one basis, LETFs aim for a 2:1 or 3:1 ratio. These products are available for most indexes, such as the Nasdaq 100 Index and the Dow Jones Industrial Average.
Key Takeaways
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A leveraged ETF uses financial derivatives and debt to amplify returns of an underlying index, stock, or asset.
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While traditional ETFs track securities one-to-one, LETFs aim for a 2:1 or 3:1 ratio.
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Leverage can lead to significant gains but can also amplify losses.
Before investing, read the prospectus and understand the mechanics of these complicated instruments, as they are generally meant for short-term, day-to-day trading.
Leveraged ETFs Explained
ETFs trade like other securities on the stock market, containing a basket of securities. An LETF, in particular, uses financial products and debt to magnify gains and losses, primarily through futures contracts, index futures, and swap agreements. These derivatives require daily rebalancing, leading to compounding risks.
Management fees and transaction costs associated with LETFs can diminish the returns, with expense ratios averaging at 1.02%.
The Leverage in Leveraged ETFs
An LETF amplifies exposure to an index or asset, resetting daily. Leverage can come from borrowing or using derivatives like futures contracts, forward contracts, total return swaps, and options:
Futures Contracts
Agreements to buy or sell an asset at a predetermined price at a specific time. Traded on exchanges, these must be fulfilled at the maturity date.
Forward Contracts
Similar to futures, but are customizable private agreements not standardized.
Total Return Swaps
One party pays the total return, including dividends, interest, and capital gains of an asset, to another party paying a fixed or floating rate.
Options
Contracts that grant the ability to buy (call option) or sell (put option) an asset, different from obligations seen with futures and forwards.
A leveraged inverse ETF capitalizes on declines in the underlying index, allowing profit in bearish markets.
The Costs of Leverage
LETFs come with higher fees due to premiums, fees, and interest on derivatives. Additionally, LETFs can avoid the outsized costs associated with other forms of margin, like short selling and margin calls.
Leveraged ETFs Are Short-Term Instruments
Ideal for day trading, LETFs are unsuitable for long-term investments due to their daily resetting mechanism. They are built around daily strategies, not longer-term compounding strategies.
Pros
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Potential for significant gains exceeding tracked indexes or assets.
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Variety of securities to trade.
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Inverse LETFs offer profit potential for declining markets.
Cons
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Potential for significant losses.
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Higher fees and expense ratios.
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Unsuitability for long-term investment.
Real World Example of a Leveraged ETF
Direxion Daily Financial Bull 3x Shares (FAS) tracks large U.S. financial companies, aiming at three times the return of the moves in financial stocks. If an investor buys $10,000 of FAS and the underlying stocks rise by 1%, FAS seeks a 3% return, making the investment $10,300 excluding fees. Conversely, a 2% decline in the financial stocks results in a 6% decline for FAS, reducing the investment to $9,400.
The Impact of Daily Resets
LETFs rebalance daily, making them unsuitable for long-term buy-and-hold strategies. This mechanism means they won’t accumulate gains or losses, often diverging from simple 3x multipliers of the underlying index.
For instance, consider FAS:
- Day 1: +1.0%, hence FAS = +3.0%
- Day 2: -2.0%, hence FAS = -6.0%
- Day 3: +0.5%, hence FAS = +1.5%
A $10,000 investment experiences complex changes, diverging significantly from simplified expectations due to these daily resets.
Leveraged ETFs and Their Risks
Tax Implications
Frequent trading and rebalancing trigger higher short-term capital gains, taxed higher. Derivatives add to tax complexities; consulting a tax specialist is advisable.
Interest Rate Changes
Interest rates significantly affect fixed-income LETFs, influencing sectors or assets they track.
Leveraged ETF vs. Margin Trading
LETFs inherently incorporate leverage to deliver daily performance multipliers, whereas margin trading involves borrowing to invest with its associated risks, including margin calls.
The Bottom Line
LETFs deliver amplified daily performance of specific indexes or assets using derivatives. They suit experienced traders focusing on short-term strategies requiring quick, significant market exposure. However, they are complex, prone to higher costs, and unsuited for long-term investments due to daily rebalancing impacts. Careful understanding and caution are essential due to the heightened risks and volatility LETFs bring compared with traditional ETFs.
Research and comprehend all facets before engaging in LETF investments to align with your financial goals and risk tolerance.
Related Terms: Exchange-Traded Funds (ETFs), futures contracts, margin trading, inverse ETFs, derivatives.
References
- Securities and Exchange Commission. “Updated Investor Bulletin: Leveraged and Inverse ETFs”.
- Securities and Exchange Commission. “Statement on Single-Stock Levered and/or Inverse ETFs”.
- D. J. Abner. The ETF Handbook: How to Value and Trade Exchange Traded Funds. John Wiley & Sons, 2016. Pages 267-273.
- Securities and Exchange Commission. “Remarks Before the 4th Annual Art of Indexing Summit”.
- G. L. Gastineau. The Exchange-Traded Funds Manual. John Wiley & Sons, 2010. Pages 247-262.
- Financial Industry Regulatory Authority. “Exchange-Traded Funds and Products: Types”.
- Peter Miu and Narat Charupat. Leveraged Exchange-Traded Funds: A Comprehensive Guide to Structure, Pricing, and Performance. Springer, 2016. Page 25.
- Financial Industry Regulatory Authority. “The Lowdown on Leveraged and Inverse Exchange-Traded Products”.
- ETF.com. “Leveraged ETFs”.
- Peter Miu and Narat Charupat. Leveraged Exchange-Traded Funds: A Comprehensive Guide to Structure, Pricing, and Performance. Springer, 2016. Pages 5-11.
- Peter Miu and Narat Charupat. Leveraged Exchange-Traded Funds: A Comprehensive Guide to Structure, Pricing, and Performance. Springer, 2016. Page 24.
- U.S. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options”.
- Peter Miu and Narat Charupat. Leveraged Exchange-Traded Funds: A Comprehensive Guide to Structure, Pricing, and Performance. Springer, 2016. Page 8.
- Financial Industry Regulatory Authority. “Brokerage Accounts: Margin Accounts”.
- Direxion. “FAS FAZ”.
- Peter Miu and Narat Charupat. Leveraged Exchange-Traded Funds: A Comprehensive Guide to Structure, Pricing, and Performance. Springer, 2016. Chapter 2.
- U.S. Securities and Exchange Commission: “Updated Investor Bulletin: Leveraged and Inverse ETFs”.
- Peter Miu and Narat Charupat. Leveraged Exchange-Traded Funds: A Comprehensive Guide to Structure, Pricing, and Performance. Springer, 2016. Page 26.
