When the phrase "leveraged ETFs" graces the ears of Canadian investors, most minds dart straight to those designed to amplify returns, usually by doubling them. 

Familiar examples include the offerings by Horizons ETFs' BetaPro lineup, which promises both 2x long and short exposure to significant benchmarks such as the S&P 500, Nasdaq 100, and S&P/TSX 60 indexes. 

But as enticing as doubling your potential upside might seem, there's a catch: these funds are not structured for the long haul. The daily resetting of the leverage target, coupled with high expense ratios and the adverse effects of volatility drag, makes them a risky proposition for an extended holding period.

Historically, investors looking for long-term leverage would find their options restricted to using a margin account. But the Canadian ETF landscape is evolving. 

Recent innovations from not just Horizons, but also from Hamilton ETFs and Harvest ETFs, have seen the introduction of what some are calling "lightly leveraged" or "modestly leveraged" ETFs. 

These funds, which provide a 1.25x exposure, mark a significant departure from the traditional 2x daily leveraged products. Intended for buy-and-hold strategies, these new entrants are, as of now, a peculiarly Canadian offering. 

So, what's the story behind these lightly leveraged funds, and how can they fit into a diversified investment strategy? Let's delve into the intricacies and break down the leading products in this space.

How these new ETFs differ

Most investors have a basic understanding of traditional ETFs that mirror the performance of a benchmark index. Enter leveraged ETFs: their primary goal is typically to provide an amplified return, usually twice (or 2x) that of their reference index on a daily basis.

Let's conceptualize this with a hypothetical scenario: Imagine a 2x leveraged ETF that tracks the S&P 500. If the S&P 500 gains 1% on a particular day, the 2x leveraged ETF aims to deliver a 2% return on that same day. Conversely, if the S&P 500 drops by 1%, the ETF would likely fall by about 2%.

However, this dynamic introduces a compounding effect, especially in volatile markets. Consider a scenario where the S&P 500 goes up by 10% one day and drops 10% the next. An investor might intuitively expect a 2x leveraged ETF to deliver twice that movement. However due to daily rebalancing and the compounding effect, the actual return can differ significantly over multiple days, especially in a choppy market.

Leverage in these ETFs is usually achieved through swap agreements. In simple terms, a swap agreement is a contract between two parties that allows them to exchange financial instruments, in this case, the returns from the benchmark index for the leveraged returns. 

It's a derivative instrument, meaning its value is derived from another asset (in this case, the benchmark index). Leveraged ETFs often have expense ratios of 1% or even higher due to the cost of these swap agreements and the frequent rebalancing required.

But here's where the new wave of lightly or modestly leveraged ETFs diverges. Instead of relying on swap agreements, these ETFs employ cash leverage. This is akin to borrowing cash, similar to what happens in a margin account, to amplify investment exposure. 

By capping the leverage at 1.25x, they present an entirely different risk-reward profile. The benefits of this approach are manyfold. Firstly, with less leverage, there's a reduced risk of a total loss. Secondly, this method inherently leads to lower volatility. 

The more tempered 1.25x amplification can potentially offer a smoother ride for investors, especially those with a longer time horizon, making it a suitable strategy for a buy-and-hold investor.

The current ETFs available

The Canadian ETF landscape has seen an influx of these modestly leveraged funds, and many of them are signposted with the term "Enhanced" in their name. However, this moniker alone doesn't provide a comprehensive understanding of the product's structure and strategy. 

As with any financial instrument, the devil is often in the details. Therefore, reading the factsheet of the ETF provides a good overview, but diving into the prospectus offers an in-depth understanding of its workings, potential risks, and rewards.

An interesting trait among several, but not all of these ETFs is the incorporation of covered call strategies alongside their leveraged exposure. Covered calls involve selling call options on assets you own, which can generate additional income. 

In the context of these ETFs, it means investors are not only benefiting from the amplified returns due to the 1.25x leverage but also receiving income from the options market. This combination can be attractive, especially in flat or moderately bullish markets where the options income can provide a cushion or enhance overall returns.

Moreover, when these ETFs are based on underlying assets that pay dividends, the leverage can work its magic there too. For instance, if an underlying asset within the ETF pays a dividend, the 1.25x leverage will often magnify that dividend payout, leading to heftier yields for the investor. 

However, it's crucial to remember that the same mechanism that magnifies returns can also amplify losses. Investors should expect these ETFs to have higher volatility compared to their non-leveraged counterparts. 

Here's a comprehensive list of the major offerings from Hamilton, Horizons, and Harvest:

• Hamilton Enhanced Utilities ETF (HUTS)
• Hamilton Enhanced Canadian Bank ETF (HCAL)
• Hamilton Enhanced Canadian Financials ETF (HFIN)
• Hamilton Enhanced Multi-Sector Covered Call ETF (HDIV)
• Hamilton Enhanced U.S. Covered Call ETF (HYLD)
  
• Harvest Healthcare Leaders Enhanced Income ETF (HHLE)
• Harvest Brand Leaders Enhanced Income ETF (HBFE)
• Harvest Tech Achievers Enhanced Income ETF (HTAE)
• Harvest Equal Weight Global Utilities Enhanced Income ETF (HUTE)
• Harvest Canadian Equity Enhanced Income Leaders ETF (HFLE)
• Harvest Diversified Monthly Income ETF (HDIF)
  
• Horizons Enhanced US Large Cap Equity Covered Call ETF (USCL)
• Horizons Enhanced Canadian Large Cap Equity Covered Call ETF (CNCL)
• Horizons Enhanced Equal Weight Banks Index ETF (BNKL)
• Horizons Enhanced Equal Weight Canadian Banks Covered Call ETF (BKCL)
• Horizons Enhanced S&P/TSX 60 Index ETF (CANL)

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.