Wall Street has come up with super leveraged funds called Leveraged ETFs, a fund that uses debt and financial derivatives to increase the returns of the underlying index. Since 2014, more than 160 leveraged ETFs, worth approximately $23 billion have been created by investment companies. However, these funds differ from each other in terms of objectives and degrees of leverage, aiming to double or even triple the daily performance of a certain index or asset class.
For the uninitiated, ETF stands for Exchange Traded Funds, a type of mutual fund that is accumulated into shares and traded on an exchange with its own ticker symbol. Let us go into few details.
What is an ETF?
Exchange Traded Funds are traded just like stocks, with their own ticker symbol, but they function just like mutual funds. So, your returns will depend on the type of investments you hold. You can invest in stocks, commodities like gold and silver, or bonds or even in a known and reliable index like the Dow Jones Industrial Average or the S&P 500.
The S&P 500 index, for example, is one of the most popular ETF investment options in the world, since it is the easiest way for an average investor to gain exposure to the entire US stock market with just a click. The official name is SPDR S&P 500 ETF, but it is also referred to as Spy ETF. It is one of the oldest ETFs in the market and is known for its huge liquidity. Most ETFs are significantly cheaper than mutual funds, and so is Spy. It charges only 0.09%, lower than most mutual fund options out there. Spy ETF has a long track record of giving its investors significant returns, making it a great option for both experienced and novice investors alike.
How do leveraged exchange traded funds work?
If as a trader, you are interested in speculating on an index or taking advantage of an index’s short-term momentum, then leveraged ETFs are good for you. These funds use derivatives like daily futures contracts to magnify the exposure to a particular index. If you are going for a leverage fund with a 1:2 ratio, it means that for every dollar you invest, an additional dollar of invested debt will be matched to it. If your underlying index returns 1% on any given day, the fund should return you 2%.
It is important to note, however, that this 2% return is just theoretical, since there are transaction costs and management costs involved too. This will be applicable for the losses as well. If the index loses 1%, the fund will take a hit of 2%.
Advantages of leveraged ETFs
They are a good fit for a short-term investment horizon. They aim to achieve investment returns by targeting the daily returns or daily magnified performance of their underlying benchmarks. In long-term investments, their performances could deviate according to their respective underlying assets too. If you want to invest in the long-term gains or losses of an industry sector or any particular asset class, then this is not a suitable choice for you. But, the good news is that product developers are already working on exchange traded funds that can magnify performance returns over the long-term too.
Like any ETF, leveraged ones also increase your exposure to a variety of investment sectors. You can use them to speculate on the prices of oil, metals, currencies, company stocks and bonds, and more. This is a good way to diversify your risk. Since management expense ratios tend to be lower than that of mutual funds, leveraged ETFs are mostly cheaper than mutual funds.
The last and most significant benefit is that of leverage. You get to multiply your gains and will not lose more than the entire investment, in case the markets go against you. This is much better than short selling your stocks, where you could lose several times your entire investment amount.
Risks you should know about
Like any investment option, there are risks involved in leveraged ETFs too. They rebalance on a day-to-day basis and are highly sensitive to market volatility. This means that over time, you could lose money, even if the underlying asset breaks even.
Leveraged ETFs do not own the leveraged portfolios that they are providing you exposure to. Usually, they will borrow funds from a bank or an investment firm, and if these institutions go bankrupt, the fund will not be able to give you the promised returns. This is something called ‘Counterparty Risk’. These risk factors make it necessary for every trader to apply some risk management strategies even when they invest in exchange traded funds.
Risk management tips for leveraged ETFs
Avoid overnight positions
Remember that these investment options are good for short-term benefits. Your ETF could gather 10% gains on a particular day, only to lose 10% in the next trading session. This could go on for a number of days, reducing the total profit in the end.
Take note of the reset period
Leveraged exchange traded funds reset their exposure daily. In a week, the performance of an ETF will depend on the path taken throughout the 7 days. This path is clearly visible in trending markets, but not in volatile ones. Beware of eroding returns. Active traders should always keep track of their positions.
Be aware of counterparty risks, liquidity risks, and increased correlation risks
Leveraged ETFs are definitely riskier than their non-leveraged counterparts. Leverage is a double-edged sword, so be sure to follow your risk management strategy. Leveraged ETFs use financial derivatives, so there is an element of increased correlation risk. They are not suitable for retirement portfolios that are looking for low beta coefficient.
Leveraged ETFs are great for investors who want to leverage their position without the use of margin. It has been asserted time and again that they are suitable for short-term investors. Traders should also keep an eye on the transaction costs, which can impact returns.