Leveraged ETFs are a type of security that uses debt to amplify the earnings of its shareholders. While a traditional ETF follows an index on a one-to-one basis, a leveraged fund usually targets a 2:1, and sometimes even a 3:1 ratio. Does this also mean that investors can lose all their money or more with a leveraged ETF?
In theory, leveraged ETFs could get to zero when a 3x leveraged fund drops 33% in value in a single day. Such huge drops rarely happen, though. Typically, when a leveraged ETF loses most of its value, it gets redeemed or has a reverse split. Leveraged ETFs cannot go negative on their own.
The rest of this article will explain in more detail what leveraged ETFs are, how they work, and how their price changes.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
How Do Leveraged ETFs Work?
Leveraged ETFs are exchange-traded funds that allow investors to exploit leverage in their portfolios. In this context, leverage is a way of using borrowed capital to increase investment exposure. That will enable investors to make more profits without adding margin.
The way leveraging is made possible is by borrowing debt and swaps. This borrowing process is what brings up the cost of leveraged ETFs’ transactions and management fees.
US Stock Exchanges currently hold 186 Leveraged ETFs. The most popular ones track significant indexes like the S&P 500, Dow Jones, and others. Leveraged ETFs can also track industries or an asset class.
Types of Leveraged ETFs
The two most common types of ETFs are:
- 2:1 or 2x. The fund will yield twice the returns of its underlying index. For example, a 5% index price increase will result in a 10% increase in the fund.
- 3:1 or 3x. The fund will yield thrice the returns of its underlying index. For example, a 5% index price increase will result in a 15% increase in the fund.
The two types work in the same way. A 3x fund carries more significant risk but also the potential of higher profits.
There are also 1.5x and 5x leveraged ETFs, but they are a lot rarer.
Inverse Leveraged ETFs
An inverse leveraged ETF is a fund that invests against a particular index, meaning that you earn money when the index price falls.
If you are very pessimistic about the market or about a particular index, you can use leverage to maximize your profits.
Since most experts and everyday traders are optimistic about the market in the long term, this isn’t a strategy you should use for anything other than short-term gains.
Are Leveraged ETFs a Good Investment?
In general, leveraged ETFs can be a good investment but should only be utilized by experienced traders who are willing to take on greater portfolio risk.
Leveraged ETFs reset daily. Thus the fund only pays out returns based on the underlying index for a particular day and not over longer periods. That can cause volatility to eat away at gains, also called volatility decay. Volatility decay is the main reason why investment consultants are highly against leveraged ETFs for a long-term investment strategy.
With that said, volatility decay can also work out for the benefit of the investor. As an example, the 3x leveraged S&P 500 ETF has delivered nearly five times the returns of the index instead of the proposed 3. Despite being risky, investors can use leveraged funds to maximize returns during a bull run.
If you are a novice investor, I would highly recommend that you stay away from leveraged ETFs, at least until you feel more comfortable with the market. However, that doesn’t mean that you should abandon them as an option altogether.
Reasons To Invest in Leveraged ETFs
Here are four key trading methods and reasons to invest in leveraged ETFs:
Swing Trading
Swing trading is a trading strategy that incorporates technical analysis to make a profit on a stock in the short term. This strategy should only be used by seasoned investors with years of experience in the market.
These investors can swing trade leveraged ETFs to try and maximize their profit. Again, this is incredibly risky and should never be used as a long-term trading strategy.
Trend Following
If you are looking to capitalize on an emerging trend or a new development, leveraged ETFs can help you make the most of your initial investment.
You should conduct a thorough research about a trend before putting a significant amount of money into a fund.
Earnings Announcement
During a period called earnings season, many companies publicly announce their quarterly and yearly earnings. By analyzing these reports, investors can gauge the trend of the companies’ shares and make the most of the information by investing in leveraged ETFs.
Long-Term Holding
In cases like the 3x S&P 500 leveraged ETF, long-term holding of such funds can be highly profitable. It is a fact that most of the popular indexes and the stock market as a whole have been trending up with no signs of slowing down.
Some investors with a high-risk tolerance utilize leveraged ETFs to try and maximize their potential earnings over a more extended period.
Can You Lose More Than You Invest?
While you can undoubtedly lose 100% of your initial investment, you can never lose more than you invest with leveraged ETFs, as they can’t go below zero.
In that sense, leveraged funds are safer than the accumulation of margin or short-selling, which can bring unlimited losses to investors.
It is also relatively rare for people to lose more than 50% of their investment. Usually, when such declines happen, fund managers are quick to react.
What Are the Risks of Trading Leveraged ETFs?
Leveraged ETFs carry a much more considerable risk than traditional ETFs and many other investment options. Higher risk is the price you have to pay for the increase in potential profit. For this reason, leveraged ETFs are only recommended for experienced traders.
Here are some of the main risks associated with leveraged ETFs:
The Amplification Goes Both Ways
The most noticeable risk is the fact that the amplification of the index goes both ways. While you can learn twice or thrice as much from an index on a particular day, you can also lose as much if the index is trending down.
So, you are essentially taking on more risk in exchange for higher profit potential.
Not Ideal Long-Term Option
Despite some known cases of leveraged ETFs working incredibly well over a more extended period, many professionals still advise against holding leveraged ETFs over the long term.
There are two main reasons for that:
- Much higher management fees than traditional ETFs
- If the market is highly volatile, the unleveraged investor will experience greater returns than the leveraged investor.
- Leveraged ETFs reset daily, meaning that a 2x fund will only double for a single day. Over the long term, there is usually quite a large discrepancy between the leveraged ETF price and the actual value of the index.
The Plain Bagel offers a great explanation of how leveraged ETFs can be risky in this video:
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
- Best Trading Courses You Can Take For Free (or at extremely low cost): I reviewed 30+ trading courses to recommend you the best resource, and found Trading Strategies in Emerging Markets Specialization on Coursera to beat every other course on the market. Plus, if you complete this course within 7 days, it will cost you nothing and will be absolutely free! Click Here To Sign Up Today! (If you don’t find this course valuable, you can cancel anytime within the 7 days trial period and pay nothing.)
- Best Passive Investment Platform For Exponential (Potentially) Returns: By enabling passive investments into a Bitcoin ETF, Acorns gives you the best opportunity to make exponential returns on your passive investments. Plus, Acorns is currently offering a $15 bonus for simply singing up to their platform – so that is one opportunity you don’t want to miss! (assuming you are interested in this platform). Click Here To Get $15 Bonus By Signing Up For Acorns Today! (It will take you less than 5 mins to sign up, and it is totally worth it.)
Conclusion
Leveraged ETFs rarely reach a price close to zero, and they can’t go negative. Before anything like that happens, the fund managers either reverse split the fund’s shares or redeem the shareholders with whatever is still left.
Leveraged ETFs reset daily, which is why they are only recommended for short-term trading. However, more experienced investors have on occasion made fortunes utilizing this investment vehicle.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
Affiliate Disclosure: We participate in several affiliate programs and may be compensated if you make a purchase using our referral link, at no additional cost to you. You can, however, trust the integrity of our recommendation. Affiliate programs exist even for products that we are not recommending. We only choose to recommend you the products that we actually believe in.
