What are Leveraged ETFs?
Investing in Leveraged ETFs entails a great number of implications. In this article we take a deep dive into Leveraged ETFs and explain what they mean.
For those following the markets, chances are they came across Leveraged ETFs least once. These financial instruments caught the attention of both institutional and retail investors. On one hand, institutional investors employ them as tools for short-term hedging, arbitrage, and statistical strategies. While on the other hand, individual investors view these instruments as a mean to boost their returns.
What are Leveraged ETFs?
By design, ETFs track the price movement of an index. Leveraged ETFs aim to deliver multiples of the return of the underlying securities. They employ financial derivatives and debt to amplify the securities' daily price movement. There are different leverage ratios, but double-leveraged (2x) and triple-leveraged (3x) are the most common.
Similarly Inverse ETFs, aka Bear ETFs, seek to deliver the opposite of the performance of the underlying securities. There are also Leveraged Inverse ETFs that aim to deliver -2x of the indexes’ performance.
Daily leverage and short-term positions
Leverage ETFs are useful in a trending market where they create a positive amplification. While Bear ETFs are better suited for a none trending market. They create negative amplification in such scenarios.
A misconception about Leveraged ETFs is that they continuously amplify monthly or annual returns which is not really the case. An investor might wrongly assume that if the underlying securities increase 4%, then the corresponding double-leveraged ETF will return 8%. In reality, Leveraged ETFs rebalance daily to maintain a constant leverage ratio on a 1-day basis. As such, most Leveraged ETFs are marked to market and designed to achieve their objectives daily. Every day, the fund earns a return, either positive or negative, and it must reset its exposure to maintain a constant multiple to a changing asset base. Performance over periods longer than one day can significantly differ from the stated daily performance objectives.
The effect of compounding
Compounding is when an asset’s earnings are reinvested, instead of distributed, to generate more additional earning over time. In other words, compounding refers to generating earnings from previous earnings (capital gains and interest).
How does compounding work?
Consider an investor putting CAD$1000 in a 2x leveraged ETF having a CAD$2000 exposure. When underlying index rises 2% on the next day, the investor will earn CAD$40 on his leveraged exposure. On the following day, the investor will have CAD$1040 invested and CAD$2080 of exposure. Alternatively, when the underlying index declines 2%, the investor will lose CAD$40. On the following day, CAD$960 will be invested to achieve the same investment objective.
The compounding effect is reflected in both scenarios. The invested capital either increases or decreases daily with the ETFs rising and/or dropping.
Counterparty risk
Leveraged ETFs are riskier than traditional ETFs (non-leveraged) since they obtain leverage by using options, futures and/or swaps to increase their returns. The use of financial derivatives entails counterparty risk. Counterparty risk is when either party of a transaction default and fails to meet their obligations.
Fees associated with Leveraged ETFs
Management fees are levied to cover funds’ marketing and administrative costs while transaction fees result from trading derivatives instruments in the ETFs portfolio.
Other than management and transaction fees, there are further costs to be incurred. On average, Leveraged ETFs charge higher fees than traditional ETFs (non-leveraged) as they pay upfront premiums to buy financial derivatives.
Leveraged ETFs are used for short-term strategies
Leveraged ETFs are rarely used in long term strategies, due to their high risk and high-cost structure. They are designed to take advantage of short-term opportunities over one day periods. As such, these instruments tend to be less tax-efficient than traditional ETFs. Daily resets can cause the funds to realize short-term gains. These gains are subject to a higher “short term capital gains” tax rate if they are not offset by losses.
Things to consider before investing in Leveraged ETFs
Investing in Leveraged and Inverse ETFs entails higher risks than other investments. The best form of protection is understanding the product before investing. Investors should read the fund’s prospectus which provides details about the investment thesis and strategy. Contacting an investment professional is also a good option.
Below are few questions to think about before investing in Leveraged ETFs:
- How does the fund achieve its stated objectives?
- What if the fund is held for more than one trading day?
- What are the tax consequences?
