The Ultimate Guide to Leveraged ETFs: Their Uses, Their Risks, and More

by on April 27, 2009 | Updated November 1, 2012 | ETFs Mentioned:

In the past few years the interest in leveraged ETFs has skyrocketed. With this new level of interest, so too has criticism of these funds increased. The truth is however most financial products, Mr. Madoff aside, aren’t “good” or “bad”–they’re appropriate for some goals, and inappropriate for other goals. Let’s take a look at leveraged ETFs, and how they can be intelligently utilized.

http://en.wikipedia.org/wiki/New_York_Stock_ExchangeHow Exactly Does a Leveraged ETF Work?

A leveraged ETF is not actually that complicated. It simply combines two things: leverage… and (wait for it!) an ETF. A leveraged ETF works like any other passively-managed ETF: it tracks an index. Additionally, it uses borrowed money towards the goal of increasing returns. (Though, note that both returns and losses are magnified when you invest with leverage.) Usually, every one dollar of investor equity is combined with one dollar of borrowed money. A 1:1 ratio such as this would make for a “2X” leveraged ETF.

At first glance you might think a leveraged ETF simply doubles the annual return or loss of the index it tracks. This isn’t what occurs happens however since these funds actually double the daily return. (Why do they do this? We’ll explore this below, but the short answer is, because they’re meant to be used by day traders.) For example, the leveraged ETF DDM is structured to gain 2% on a day when the Dow Jones Industrial Average gains 1% (and to lose 2% when the Dow loses 1%). But in the long run, a “2X” leveraged ETF will not achieve twice the annual return or loss of the index it tracks, but instead will achieve an annual return that is highly dependent on daily swings [Download 101 ETF Lessons Every Financial Advisor Should Learn].

If the preceding paragraphs scared you a bit, that’s OK. Leveraged ETFs are risky and should be used with care. Another risk to be aware of is the constant leverage trap (explained in this SeekingAlpha article):

In order to deliver the 2x results that the fund’s investors expect, fund management has to hold equal proportions of debt and equity at all times… Whenever the market makes a big move downward, the fund sells shares and reduces its debt level in order to maintain its target leverage ratio. This locks in losses and reduces the fund’s asset base, making it much harder to recover gains in the next market upturn.

If you’re a buy-and-hold investor whose IRA contains only SPY and TIP, I’ve probably scared the pants off of you! That’s OK, leveraged ETFs may not be for you, but they do have their uses. [For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro]

Appropriate Uses for Leveraged ETFs

So who would want to use a leveraged ETF? As is pointed out in this ETFTrends article, it appears that leveraged ETFs are mostly traded by institutional investors, with short-term goals far different than that of a normal retail investor. And day traders following their own short term strategies can use them, too, as a more efficient way to “trade on margin.”

Both day traders and institutional investors were already trading indexed securities with leverage; leveraged ETFs just provide a more efficient vehicle for them to do that. Rather than borrowing money from your broker, and making sure you have enough reserve capital to do so, you can just buy an ETF with your cash on hand. Thus, the real value in a leveraged ETF is that its a more efficient way to meet a very specific goal. There’s nothing wrong with that, as long as less-educated retail investors don’t get “sucked in”–and in fact, leveraged ETF issuers are very clear in all of their marketing and informational materials that leveraged ETFs are risky and not appropriate for many investors.

Who Should Not Use Leveraged ETFs

At this point, you may have concluded that you’ll never want to use a leveraged ETF, if you fall into one of the following categories:

  • You’re a long-term, buy-and-hold investor using a widely-recommended all-ETF portfolio such as ETFdb’s Sample Portfolio.
  • You don’t day trade.
  • You’re not an institutional investor.

That’s 100% fine. You’ll never want to buy a leveraged ETF. At least know you know why you’ll never want to!

Further Reading on Leveraged ETFs

If you want to learn more about leveraged ETFs, I recommend the following resources:

Disclosure: At the date of publishing, the author currently owns shares of an ETF mentioned in this article: TIP.