Read Now: Q&A with Kevin O'Leary & Connor O'Brien from O'Shares

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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 of a 3x ETF 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.

For a more in-depth explanation regarding this question, please read The Curious Case Of Leveraged ETFs: Understanding How Compounding Works.

Q: What are the tax consequences of leveraged ETFs?

figuring out tax bill

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.

Q: How can a Bull and Bear ETF that track the same index have a negative return for the same period?

A: Over periods of time that are longer than the fund’s stated holding period, especially when markets experience significant market volatility, investment results can vary. The path of the benchmark index during these longer periods may be at least as important to the fund’s return as the cumulative return of the benchmark for the period.

As a result, even though the benchmark index had a positive return, a bull fund that tracks it can have a negative return, due to the product of the daily (or monthly in the case of funds tracking a monthly holding period) events that take place during the said time period.

Q: What are some common uses for leveraged and inverse funds?

A: Leveraged funds are often used to help manage risks in other investments and allow investors to hedge their exposure to sectors they are overweight in. They are also often used to capture returns while eliminating market or sector exposure or to overweight a particular sector by using minimal amounts of cash.

Q: Can I lose more than my initial investment in short leveraged funds?

A: No, you can never lose more than your initial investment when using leveraged funds. This is in stark contrast to buying on margin or selling stocks short, a process that can cause investors to lose far more than their initial investment.

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