Leveraged Commodity ETFs: How They Work and How to Use Them

Leveraged commodity ETFs can be a powerful tool for investors looking to amplify their returns in a specific market. They achieve this by using derivatives, such as futures contracts, to gain exposure to a commodity.

These ETFs are designed to track a particular index or commodity, but with a twist: they aim to deliver a multiple of the index's daily performance. For example, a 2x leveraged gold ETF will attempt to return twice the daily change in the price of gold.

However, it's essential to understand that these ETFs are not a guarantee of success and come with significant risks. The article highlights that leveraged commodity ETFs can experience significant losses if the market moves against them, and the fees associated with these ETFs can be substantial.

Investors should be cautious and do their research before investing in leveraged commodity ETFs, as they require a solid understanding of the underlying market and the ETF's mechanics.

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An ETF, or exchange traded fund, is a security that tracks the performance of an underlying index or asset.

ETFs can track a wide range of assets, including indexes like the Nasdaq 100 Index and the Dow Jones Industrial Average.

Some ETFs are traditional, meaning they track the underlying index on a one-to-one basis.

A traditional ETF will typically aim to replicate the performance of the index it's tracking.

Leveraged ETFs are a type of investment that uses borrowed funds to amplify the returns of a particular index or asset. They can be used to track a variety of assets, including commodities.

Most leveraged ETFs aim to amplify daily changes, resetting each day, but some can have longer reset periods. This is done by using derivatives such as futures contracts, forward contracts, total return swaps, and options.

Futures contracts are agreements to buy or sell an asset at a predetermined price at a specific time, while forward contracts are customizable private agreements to trade an asset at a set price in the future. Total return swaps involve one party paying the total return of a tracked asset to another party, while options grant an investor the ability to buy or sell an underlying asset without the obligation to do so.

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Options have upfront fees called premiums, which can add to the gains for LETFs over traditional ETFs. Employing derivatives for generating returns is a method known as "synthetic replication", which is generally more efficient than borrowing to buy the securities of the benchmark.

The leverage in LETFs can come from borrowing or derivatives, and it can amplify both gains and losses. For example, a fund that aims to have twice the return of the targeted assets might take your invested funds and then borrow the same amount to effectively double how much is invested.

Here's a breakdown of the common derivatives used in LETFs:

Investors should be aware of the risks of LETFs, as the risk of loss is far higher than that of traditional investments. The management fees and transaction costs associated with LETFs can also diminish the fund's return, with the average expense ratio for LETFs in the U.S. markets being 1.04%.

Commodity ETFs are exchange traded funds that invest in physical commodities like agricultural goods, natural resources, and precious metals. They can be focused on a single commodity or a broad commodity index.

Investors often purchase commodity ETFs to hedge against inflation or make a profit when the stock market is struggling. Commodity ETFs carry risk and are not a guarantee of profit.

Commodity ETFs can be invested in physical storage or derivatives positions, making them a versatile investment option.

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Commodity ETFs are a type of investment that allows you to own a piece of a commodity without actually owning the physical asset. They're often made up of futures or asset-backed contracts that track the performance of a particular commodity or group of commodities.

Instead of owning the physical asset, you own a set of contracts backed by the commodity itself. This is a key difference between commodity ETFs and normal ETFs, which are made up of public equities.

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Commodity ETFs can be focused on a single commodity held in physical storage or investments in commodities futures contracts. Some track the performance of a broad commodity index that includes many individual commodities.

Investors often purchase commodity ETFs to hedge against inflation or to see profits when the stock market is sputtering. However, it's essential to remember that commodity ETFs carry risk and are not a guarantee of profit.

Commodity funds often create their own benchmark indexes that may include only agricultural products, natural resources, or metals. This can result in tracking error around broader commodity indexes.

Commodity ETFs have become increasingly popular because they give investors exposure to commodities without requiring them to learn how to purchase futures or other derivative products.

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Commodity ETFs are often compared to another investment product called Exchange Traded Notes (ETNs). An ETN is a debt instrument issued by a bank with a maturity date and is backed by the issuer.

ETNs are senior, unsecured debt instruments. They are backed by the issuer, which means they have a higher claim on the issuer's assets in case of bankruptcy.

One key difference between commodity ETFs and ETNs is how they track the underlying asset. ETNs use different strategies, including buying stocks, bonds, and options, to match the returns of the underlying asset.

ETNs have limited tracking error between the ETN and the asset it is tracking. This means that the ETN's performance is closely tied to the performance of the underlying asset.

Investors in ETNs only pay capital gains tax when the ETN is sold, not when they're holding it. This can be beneficial for investors who plan to hold onto their ETNs for an extended period.

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Contango is the pricing situation found with futures contracts where longer-dated futures consecutively trade at higher prices than the spot contracts.

This means that time premium and/or carry costs for commodities make long-dated futures more expensive than near-term or current month futures. Approximately 80% of the time, futures markets are in a state of contango.

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Leveraged ETFs on the VIX, crude oil, gold, and even the S&P 500 all fall under contango pricing. These ETFs aim to mirror the one-day performance of the underlying index or commodity.

However, during contango periods, ETFs can't roll over futures, instead they buy the further out futures at a higher price to replace the current futures being sold at a lower price. This results in decay over time.

Long-term investors should never hold these ETFs in a portfolio as the time decay erodes value. For example, leveraged ETFs like the UVXY tend to lose 8 to 10% monthly during low volatility periods.

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Leverage in leveraged commodity ETFs can be a double-edged sword, as it amplifies both gains and losses. The leverage comes from borrowing and employing derivatives like futures contracts, forward contracts, total return swaps, and options.

These derivatives allow for synthetic replication, which is generally more efficient than borrowing to buy the securities of the benchmark. Options, in particular, have upfront fees called premiums that can add to the gains for LETFs.

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Here are some examples of derivatives used in LETFs:

ETFs may influence futures prices themselves due to their need to buy or sell large numbers of futures contracts at predictable times. This places the ETFs at the mercy of traders who may bid prices up or down in anticipation of the ETF trade orders.

The cost of leverage is a crucial aspect to consider when investing in leveraged ETFs. Many LETFs have expense ratios of 1% or more, which is higher than non-leveraged ETFs.

These higher fees are due to premiums, fees, and interest paid on derivatives and for margin costs. Trading on margin involves a broker lending money to a customer, and the broker also charges an interest rate for the margin loan.

Short selling, which involves borrowing shares from a broker, can carry fees of 3% or more on the amount borrowed. Using margin to buy stock can become similarly expensive and can result in margin calls if the position begins losing money.

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A margin call happens when a broker asks for more money to shore up the account if the collateral securities are losing value and fall below a certain minimum. This can be a costly and stressful experience for investors.

In comparison, LETFs often have lower fees than other forms of margin. However, it's essential to carefully consider the costs associated with LETFs before investing.

Here's a comparison of the costs associated with LETFs and other forms of margin:

Keep in mind that these fees can add up quickly, so it's essential to carefully review the costs associated with LETFs and other investment methods before making a decision.

Futures-based commodity ETFs can influence futures prices due to their predictable trade orders, which may be anticipated by traders.

This can cause prices to be bid up or down in anticipation of the ETF trade orders, making it difficult for the ETF to track commodity prices accurately.

ETFs are also limited in the size of the commodity positions they can take on due to commodity trading regulations.

As a result, investors should be aware of these potential risks and consider them when investing in futures-based commodity ETFs.

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Extreme contango and backwardation can have a significant impact on the value and functionality of exchange-traded funds (ETFs). On April 23rd, 2020, May crude oil futures went negative, sinking to -$34 per-barrel due to a global demand freeze from the COVID-19 pandemic and oversupply.

The buyers refused to take delivery due to the high carry costs of storage, which caused the contract price to go negative. Each contract represented 1,000 barrels of crude oil.

The United States Oil Fund (NYSEARCA: USO) ETF collapsed and malfunctioned as a result of extreme contango. This event had a lasting ripple effect, not only causing a loss of value but also a loss of confidence in widely held ETF products.

In volatile conditions, the returns of a 3x Leveraged Exchange-Traded Fund (LETF) can significantly diverge from a simple multiplier of the underlying index's returns.

The 3x LETF can decline more than 1.7% over a three-day period, whereas the index itself declines only 0.5% over the same period.

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The daily reset mechanism in LETFs can cause their returns to deviate from the expected multiplier effect.

This is because the sequence of daily gains and losses matters, and can lead to inconsistent results over longer periods.

For example, a 3x LETF may not achieve a consistent 3x return compared with the tracked index or assets for longer periods.