In the past few years, exchange-traded funds, or ETFs, have become increasingly popular investment options. These funds grew to prominence because they offer investors significant advantages over traditional mutual funds. One is liquidity; an ETF can be traded all day during normal market hours whereas mutual funds are priced and traded once at the end of the day. Moreover, ETFs frequently carry lower expense ratios than do mutual funds.

A specific kind of ETF that has caught on with many investors is the leveraged ETF. Below we offer an investor’s guide to these vehicles.

In investing, positions are held either long or short a given security. Longs are hoping the price of the security goes up, while those shorting a stock profit when a stock price goes down. A leveraged ETF uses financial derivatives and debt to magnify the daily returns of an underlying index or asset class. The derivatives employed include, but are not limited to, options, futures, forwards, and swaps. Investors can buy a leveraged ETF that takes either a long or short position in a given index or asset class.

For example, for a leveraged ETF that takes a 2-to-1 position, the fund would return 2% for every 1% move in the underlying index or asset class. Of course, transaction costs and management fees will reduce the net return.

There are many leveraged ETFs from which an investor can choose. The ProShares Ultra Dow30 (DDM A) and ProShares Ultra S&P 500 (SSO A) ETFs seek investment returns that are twice the daily returns of the Dow Jones Industrial Average and S&P 500 Index, respectively. By contrast, an investor can utilize an inverse leveraged ETF, which allows the investor to bet against a given index or asset class, without having to actually go short. One example is the ProShares Ultra Short S&P 500 ETF (SDS A).

Leveraged ETFs are an easy way for an investor to make a particular bet for or against a specific sector of the economy. There are leveraged ETFs across most sectors of the stock market, including financials and energy.

For example, the ProShares Ultra Financials ETF (UYG A-) seeks to return twice the daily return of the Dow Jones US Financials Index. As the financial sector has recovered strongly since the crisis of 2008, this fund has done particularly well. In fact, it has generated a 23% compound annual return over the past five years.

There are even leveraged ETFs that magnify returns to an even greater extent. The Direxion Daily Small Cap Bear 3X ETF (TZA B+) seeks daily investment returns that are 300% of the inverse of the performance of the Russell 2000 Index.

Leveraged ETFs are commonly utilized by day traders and other investors seeking aggressive exposure. However, because of the higher risk involved in compounding daily returns, leveraged ETFs should only be considered by risk-tolerant investors.

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