Leveraged ETFs offer investors the opportunity to achieve amplified returns. They offer double or triple the performance of a popular index. But can you lose more than you invest in leveraged ETFs?
You can theoretically lose more than you invest in leveraged ETFs. However, it’s improbable on short-term leveraged ETF trades due to the structure of these types of securities. Only compounded losses on a position can lead to losing more than you invested.
The rest of this article will look more closely at leveraged ETFs, how they work, and why it’s rare to lose more than you invested.
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Table of Contents
What Is a Leveraged ETF?
A leveraged exchange-traded fund (ETF) is a security that holds shareholder and debt-equity. It uses debt to multiply the daily returns of an underlying index or asset for investors. Some leveraged ETFs may also use derivatives, such as options and futures contracts, to amplify returns.
On the other hand, non-leveraged ETFs hold only shareholder equity, directly matching an underlying asset’s performance. Investors in leveraged ETFs aim to generate daily returns that are multiple times the performance of the underlying asset or index.
For experienced short-term traders, the approach increases the possibility of turning a profit after factoring in the cost of the transaction.
How a Leveraged ETF Works?
If you invest in a 3x leveraged ETF with the NAS100 index as the underlying asset, you’ll get roughly 3% return on any trading day where the NAS100 index appreciated by 1%.
The exact profit can vary across brokers after management fees and interests on the leverage provided are deducted. However, your return will be higher than that recorded by someone else holding non-leveraged ETFs for the same day.
Most leveraged ETF positions are liquidated at the end of every trading day because of the daily resets structured into these securities.
So, assuming your broker allows you to borrow $500 at a 2% interest rate with a 10% deposit from your account, you’ll have $550 to trade a 3x leveraged ETF based on the NAS100 with. If the NAS100 moves up 1% in one trading day (3% for the leveraged ETF), your asset will be worth $566.5.
After paying back the borrowed sum and the 2% interest, you’ll be left with $56.5. Since you invested $50 originally, your profit is $6.5—a 13% profit on your original $50 investment off a 1% move in the underlying asset.
Such returns explain the allure of leveraged ETFs.
On the flip side, if the underlying asset dropped 1% in the investment window, you’ll need to pay back your broker’s $510 (borrowed capital and 2% interest) and still shoulder the equivalent 3% loss ($16.50).
The result is a net balance of $33.5—a 13% loss overall.
Why You Can Lose More Than You Invested in Leveraged ETFs?
In the example above, a losing investment equates to a 13% drawdown on your original investment of $50. With multiple consecutive similar losses, your $50 investment will deplete to zero, which means that you will owe the interest on the last borrowed sum.
A faster way of losing more than you invested is to buy and hold a leveraged ETF.
Since a leveraged ETF resets daily, your position will reduce to zero over time regardless of whether the underlying asset performs amazing over the long-term.
Remember, you’re making or losing money based on market movements within a trading day. So, holding a leveraged ETF based on an underlying asset that closed in losses for consecutive trading days will lead to compounded losses.
Why It’s Hard To Lose More Than You Invested in Leveraged ETFs?
We’ve covered reasons why it’s possible to lose more than you invested in Leveraged ETFs. However, most investors in these securities will agree that it’s extremely difficult to be in that position. Some would call it impossible. Why?
Most Brokers Have Minimum Requirements for Leveraged ETF Trading
In most cases, you need to have at least 10% of the amount you intend to borrow in your account. That threshold ensures you can cover interests and any other fees charged, even in the event of losses.
They also have minimum deposit thresholds.
In our example above, most brokers won’t provide leverage if you’re investing less than $50 on a specific position. With the daily volatility of most indexes, it’s impossible to lose the entire sum in one trading day.
By the end of a losing trading day, you’ll need to top up the balance above $50 to gain access to more leverage. So, there’s no chance of your original capital making a straight dash to zero.
Buy-and-Hold Leveraged ETF Trading Is Rarely Supported
It’s the riskiest form of leveraged ETF investing and the approach where you have the highest chance of losing more than your invested sum. In cases where it’s allowed, most brokers have a loss limit to ensure you don’t lose more than your capital and that you also have enough to pay the interest on the borrowed sum.
A combination of these factors means that the risk of losing more money than you’ve invested in leveraged ETFs remains a theoretical but extremely unlikely possibility.
Are Leveraged ETFs Good Investments?
Leveraged ETFs are good investments if you understand the risks involved and know how to generate consistent risk-adjusted returns with them over time. These securities should never be a part of a diversified, long-term portfolio. They’re typically not designed for a buy-and-hold approach.
They’re meant to be traded over very short timeframes—typically one day. Longer-term options aren’t any less risky.
You should also remember that the returns aren’t always as attractive as they seem on paper. The investment management fees and interest rates are always more than 1% (sometimes up to 4%). Your gains are also taxed at a much higher income tax rate because they’re classified as short-term gains.
If you’re unsure about leveraged ETFs, speak to your advisor. You’ll find out if it’s a good fit based on your broader financial situation.
What Are Safer Alternatives to Leveraged ETFs?
The safer alternatives to leveraged ETFs include buying properly vetted blue-chipped stocks and mutual funds tracking a highly diversified index like the S&P 500.
Investing in both vehicles and allowing compounding effects is a more realistic path towards generating respectable returns and beating the market.
A safer way to take more risk is to choose investment vehicles that allow both buy-and-hold investing and short-selling where possible. It’s an approach adopted by most cryptocurrency trading exchanges.
Basically, such an approach allows you to make money regardless of market direction. You can go short on trading days where you believe the underlying asset will drop in value and go long on days where you expect the asset to rise in value.
However, it doesn’t completely remove the risk of losses. Your analysis or forecast for any trading day can still be wrong. It only ensures you can take advantage of “bad” trading days for the stock market when they occur.
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Conclusion
Leveraged ETFs are one of the options available to anyone seeking amplified returns that beat the market. However, like all leveraged investment vehicles, there’s also a risk of amplified losses.
Combined with interests and management fees, the amplified losses increase the risk of losing more than you invest. However, the chances of such losses happening are very low. The broker’s terms and conditions will offer more guidance on the possibility of incurring losses beyond your invested sum.
Talk to your financial advisor before you start trading leveraged ETFs.
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