Leveraged ETF FAQs

While leveraged ETFs are in many ways relatively simple products, there are some complexities to these funds that should be thoroughly understood before investing. Below are several of the most commonly asked questions regarding leveraged ETFs and some explanations.

Q: What do leveraged ETFs hold in order to provide exposure?

A: Generally, a leveraged ETF will invest in a variety of instruments to amplify the exposure to an underlying index. In addition to equities, leveraged ETFs may use derivatives (such as futures and swaps) to gain exposure. Futures allow investors to gain exposure to a benchmark without direct ownership. These products are standardized contracts between two parties that agree to buy (or sell) an underlying index at a future date. Swaps are customized agreements between two parties to exchange sets of cash flows over a set period of time. In an equity index swap, one party generally agrees to pay cash equal to the total return on an index, while the other agrees to pay a floating interest rate.

Q: If the index to which a 3x leveraged ETF is linked is up 10% over the last month, shouldn’t the leveraged ETF be up 30%?

A: Not necessarily. Leveraged ETFs provide exposure on a daily basis, meaning that the holdings of the fund are rebalanced that frequently. Due to the effects of compounding, the return to a leveraged ETF over multiple trading sessions depends not only on the change in the underlying index, but on its path as well. If the market is a trending one (i.e., the benchmark consistently gained ground), the change in value may be more than 30%. If the market oscillated during the period in question, returns could be less than 30%, and perhaps even negative.

Q: What are the tax consequences of leveraged ETFs?

A: The potential tax efficiency of ETFs has been one of the major reasons for the surge in popularity of these products relative to traditional mutual funds. While leveraged ETFs have the potential to offer tax advantages, the issue is slightly more complex that the environment surrounding traditional ETFs.

Unlike most ETFs, leveraged ETFs generally keep a significant portion of their assets in cash, entering into swap agreements and futures contracts to achieve the desired exposure. If authorized participants redeem shares of the fund, the issuer must sell some of the underlying derivatives. If the fund has posted big gains during the year, this transaction can incur capital gains.

Capital gains distributions from leveraged ETFs became an issue in 2008 when Rydex reported distributions of as much as 70% of fund assets. In 2009, Direxion reported moderate capital gains on some of its funds while ProShares reported zero capital gains distributions.