The Pros and Cons of Investing in Leveraged ETFs
Exchange-traded funds (ETFs) are popular investment vehicles among investors due to their low fees, diversification, and ease of trading. One type of ETF that has gained popularity in recent years is leveraged ETFs. As the name suggests, leveraged ETFs use leverage to amplify the returns of an underlying index. However, as with any investment, leveraged ETFs have their pros and cons.
What are Leveraged ETFs?
Leveraged ETFs are a type of exchange-traded fund that uses financial derivatives and debt to amplify the returns of an underlying index. Typically, leveraged ETFs aim to deliver twice or three times the daily return of the underlying index. For example, if the underlying index increases by 1%, a leveraged ETF that seeks to deliver twice the daily return would increase by 2%, while a leveraged ETF that seeks to deliver three times the daily return would increase by 3%. Similarly, if the underlying index decreases by 1%, a leveraged ETF that seeks to deliver twice the daily return would decrease by 2%, while a leveraged ETF that seeks to deliver three times the daily return would decrease by 3%.
Leveraged ETFs use various financial instruments to achieve their leverage, including futures contracts, options, and swaps. In addition, leveraged ETFs often use debt to increase their leverage. This debt can come from borrowing from a bank or issuing bonds. The use of leverage can significantly increase the potential returns of leveraged ETFs but also exposes them to greater risk and volatility.
The Pros of Investing in Leveraged ETFs
Potential for higher returns: The main advantage of investing in leveraged ETFs is the potential for higher returns. Since leveraged ETFs aim to deliver twice or three times the daily return of an underlying index, investors can potentially earn double or triple the returns of a non-leveraged ETF that tracks the same index.
Low fees: Leveraged ETFs typically have low expense ratios compared to actively managed funds, making them an attractive option for cost-conscious investors. Since leveraged ETFs use financial derivatives to achieve their leverage, they do not require active management, which helps keep costs low.
Diversification: Like other ETFs, leveraged ETFs offer investors exposure to a wide range of stocks, bonds, or commodities, providing diversification benefits. For example, an investor who wants exposure to the technology sector could invest in a leveraged ETF that tracks the Nasdaq 100 Index, which includes the top 100 non-financial companies listed on the Nasdaq stock exchange.
Liquidity: Leveraged ETFs are traded on major exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq Stock Market, making them highly liquid. This means investors can easily buy and sell shares throughout the trading day at prevailing market prices.
The Cons of Investing in Leveraged ETFs
Volatility: Leveraged ETFs are exposed to greater volatility than non-leveraged ETFs due to their use of leverage. This means that the potential for higher returns comes with a greater risk of loss. For example, if the underlying index drops by 10%, a leveraged ETF that seeks to deliver twice the daily return would lose 20%, while a leveraged ETF that seeks to deliver three times the daily return would lose 30%. Therefore, leveraged ETFs are not suitable for all investors.
Complexity: The use of leverage and financial derivatives makes leveraged ETFs more complex than non-leveraged ETFs. This complexity can make it difficult for investors to understand the underlying investment strategy and the risks involved. Therefore, investors should do their research and consult with a financial advisor before investing in leveraged ETFs.
Tracking Error: Leveraged ETFs aim to deliver twice or three times the daily return of an underlying index. However, this can result in tracking errors, where the ETF’s returns deviate from the expected returns due to factors such as transaction costs and changes in the index composition. These tracking errors can result in lower returns than expected or even losses.
Long-term Underperformance: Leveraged ETFs are designed to deliver amplified returns over a short period, typically a day. However, over the long term, the compounding effect of the leverage and the tracking errors can result in underperformance compared to the underlying index. Therefore, leveraged ETFs are best suited for short-term trading and not for long-term buy-and-hold strategies.
Leveraged ETFs can be an attractive investment option for investors looking for higher returns and diversification. However, they come with greater risk and volatility than non-leveraged ETFs and require a good understanding of the underlying investment strategy and risks involved. Therefore, investors should carefully consider their investment goals and risk tolerance before investing in leveraged ETFs and consult with a financial advisor if necessary.
Ultimately, leveraged ETFs can be a valuable tool for sophisticated investors who understand the risks and can use them appropriately. As with any investment, it is important to conduct thorough research and to stay up to date on the latest developments in the market.