Leveraged ETFs and Their Impact on Investment Results

Leveraged ETFs can be a powerful tool for investors, but they can also be a double-edged sword. They allow investors to amplify their returns, but they also come with the risk of amplified losses.

Leveraged ETFs use debt to increase their exposure to the market, which can lead to significant gains, but also significant losses. For example, if you invest in a 2x ETF that tracks the S&P 500, you can potentially double your returns, but you also risk losing twice the amount you invested.

The impact of leveraged ETFs on investment results can be significant, and it's essential to understand how they work before investing. By using debt to amplify their returns, leveraged ETFs can provide a boost to an investor's portfolio, but they can also lead to substantial losses if the market moves against them.

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A leveraged exchange traded fund (LETF) is a security that uses financial derivatives and debt to amplify the returns of an underlying index or other assets it tracks. It's like a supercharged version of a traditional ETF.

Most LETFs aim for a 2:1 or 3:1 ratio, which means they'll typically double or triple the daily returns of the underlying index. This is achieved through the use of derivatives like futures contracts, forward contracts, total return swaps, and options.

These derivatives allow LETFs to magnify their exposure to the underlying asset, making them a high-risk, high-reward investment. Here are some examples of derivatives used in LETFs:

Keep in mind that LETFs can also lead to magnified losses, so it's essential to be aware of the risks involved. As a general rule, the risk of loss with LETFs is far higher than that of traditional investments.

ETFs, or exchange traded funds, are investments that represent a portfolio of securities tracking an underlying benchmark or index. They're similar to mutual funds but their prices change throughout the day, like stocks.

ETFs are subject to trading risks similar to those of stocks, including market, sector, or industry risks. This means their value can fluctuate rapidly.

Unlike traditional mutual funds, ETF prices change throughout the day, similar to stocks. This can make them a more dynamic investment option.

All ETFs are subject to market risks, which can be a concern for investors.

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Commodity-linked products like ETFs can be tricky to understand. They don't physically hold commodities, but instead hold or track indexes based on futures or other derivative products.

The value of a futures contract, which is an agreement to buy or sell a commodity at a certain date for a predetermined price, generally moves along with the spot price of the commodity or index. However, this correlation is imperfect.

To avoid taking physical possession of the underlying commodities, commodity products conduct a regular "roll" process, selling contracts nearing expiration and using the proceeds to purchase longer-dated futures contracts. This process can sometimes be more expensive than simply buying and holding the underlying commodity due to changes in the spot price of the commodity and the amount of time value in the futures contract—a situation known as "contango."

Contango can cause the performance of a commodity-linked product to deviate from the spot-price change of the commodity over the same period. If the market for a particular commodity is subject to contango, you can expect the performance of the commodity-linked product to differ from the spot price change of the commodity.

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Leveraged ETFs work by holding a combination of derivatives and actual securities to track a multiple of the underlying index's daily performance. They aim to deliver a specified return multiple, such as 2x or 3x, of the daily performance of the underlying index.

To achieve this, leveraged ETFs employ derivatives like total return swaps, futures contracts, and options. These derivatives allow the fund to gain exposure to the underlying index's return without actually owning the securities. For example, ProShares UltraPro S&P500 (UPRO) holds 77% individual S&P 500 stocks, nominal exposure to 215% of the S&P 500 through total return swaps, and 8% S&P futures.

The leverage in leveraged ETFs comes from several sources, including borrowing and derivatives. For instance, 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.

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Here are some common derivatives used in leveraged ETFs:

These derivatives allow leveraged ETFs to provide a specified return multiple, but they also come with additional risks and considerations. For example, the borrowing rate of some UPRO's swap agreements was 3.01% as of May 2019, which is not included in the fund's 0.92% expense ratio.

Daily ETF Operations are a crucial aspect of Leveraged ETFs, and understanding how they work can be a bit complex, but stick with me and I'll break it down simply.

A daily leveraged ETF holds a combination of derivatives and actual securities to track a multiple of the underlying index's daily performance. This is achieved through a combination of individual stocks, total return swaps, and futures contracts.

The daily reset mechanism causes LETFs to rebalance their portfolios daily to maintain their leverage, which means they won't necessarily work for a buy-and-hold strategy since their returns are a function of maintaining debt to equity within each fund.

To demonstrate this, let's look at an example of how a daily reset works. Here are three days of daily returns for the underlying financial index FAS:

The fund would seek to provide 3x the return of the index for each day, resulting in the following expected returns:

The fund would then reset its balances at the end of each day to maintain its leverage, which can result in significant changes to the fund's value. For example, on Day 1, the fund would need to rebalance because the value of the underlying increased by 1% while debt remained the same. On Day 2, the fund would need to sell stocks, repay debt, or do both to balance its debt-to-equity ratio.

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Inverse Strategies are designed to deliver the opposite return of an index, or a multiple of the opposite return. This means if the index rises, the inverse ETF will fall, and if the index falls, the inverse ETF will rise.

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Inverse ETFs attempt to deliver multiples in the opposite direction, so if the index rose 2%, a 2x inverse ETF would generate a negative 4% return. This is in contrast to leveraged ETFs, which aim to deliver a positive multiple of the index's return.

Inverse ETFs employ complex strategies involving derivatives, primarily futures and swap contracts, and are not designed to be held longer than the reset periods stated in their prospectuses. A fund that aims for a daily multiple shouldn't be held for longer than a single day.

The Direxion Daily Financial Bull 3x Shares (FAS) ETF is an example of a leveraged ETF, but it's worth noting that the article section doesn't provide information on inverse ETFs. However, we can infer that inverse ETFs would work in a similar way, but with opposite returns.

Here's an example of how an inverse ETF might work:

Note that this is a hypothetical example and actual returns may vary.

Leveraged ETFs can be a double-edged sword, offering significant gains but also amplifying potential losses. Between 2010 and 2019, a 2x leverage ETF on the S&P 500 index provided an annualized return of 23.6%, while a regular S&P 500 index fund provided 13.5%.

The standard deviation of monthly returns for a 2x leverage ETF on the S&P 500 index was 25.3%, more than twice that of a regular S&P 500 index fund, which had a standard deviation of 12.5%. This means that the 2x leverage ETF experienced more extreme price fluctuations.

Over the 1955 to 2019 time period, the historical simulation of a 2x leverage ETF on the S&P 500 index showed a standard deviation of 29.0%, while a regular S&P 500 index fund had a standard deviation of 14.4%. This suggests that the potential for losses increases with leverage.

A 3x leverage ETF on the S&P 500 index had an annualized return of 32.8% between 2010 and 2019, but it also experienced a standard deviation of 38.4%, which is more than three times that of a regular S&P 500 index fund. This increased volatility can make it difficult to stay invested during market downturns.

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Here's a comparison of the standard deviation of monthly returns for different ETFs:

It's essential to consider these risks before investing in a leveraged ETF, especially if you're not prepared to actively manage your portfolio.

Daily results from leveraged ETFs can be misleading. A gain of 10% followed by a loss of 10% will end up with a loss of 1.0%, not a return to the starting value.

This math applies to any investment, regardless of whether it's a single stock or a fund. The effects of compounding will also cause the fund to deviate from its stated objective over time.

A 3X leveraged fund will generate three times the gain (and loss) of an unleveraged fund over the course of a single day. However, its longer-term performance may not live up to its promise due to daily rebalancing and compounding effects.

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Daily results can be misleading, as a movement in one direction followed by an equal movement in the opposite direction will end up with a loss, not a return to the starting value.

For example, a 10% gain followed by a 10% loss will result in a 1% loss. This is just basic math.

The effects of volatility decay can be seen over time, where alternating gains and losses can lead to a lower fund value, like a 3% loss after 6 consecutive days of alternating 10% gains and losses.

A 3X leveraged fund will generate three times the gain (and loss) of an unleveraged fund in a single day, but that's not the whole story.

Leveraged funds rebalance their exposure daily, which can cause them to deviate from their stated objective over time.

Compounding can either enhance returns in trending periods or hurt returns in volatile periods, making it even more challenging for investors.

The fact sheets of these funds often include disclaimers stating that performance is only guaranteed on a daily basis.

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In volatile conditions, the returns of LETFs can significantly diverge from a simple multiplier of the underlying index's returns. This is because the sequence of daily gains and losses matters due to the daily reset mechanism.

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A 3-day loss of -1.5% for the index can lead to a LETF decline of over 1.7% due to daily rebalancing. This highlights the importance of considering the daily reset mechanism when evaluating LETF performance.

The 3x LETF, like FAS, generally should not be expected to achieve a consistent 3x return compared with the tracked index or assets for longer periods.

Leveraged ETFs come in different types, each with its own characteristics. A 3x leveraged ETF attempts to increase an index's returns by 300% by maintaining a specific debt-to-equity ratio within the fund.

There are also 5x leveraged ETFs available, such as the 5x U.S. 500 and 5x 20+ Year Treasury Bond, which offer even higher levels of leverage. These funds are designed to amplify returns, but also come with increased risk.

Some leveraged ETFs also offer inverse or short products, designed to deliver the opposite return of an index. For example, a leveraged inverse ETF attempts to use its leverage to make money when the underlying index is declining in value.

Commodity and volatility futures-linked ETFs and ETNs are investments that track changes in commodity index volatility, interest rates, or industry factors. They can be affected by market movements and are traded on an exchange like individual stocks.

These products often employ derivatives like options, futures, forwards, or other derivatives to amplify returns. This can increase volatility and may not be suitable for all investors.

Commodity futures contracts are agreements to buy or sell at a certain date for a predetermined price, moving in tandem with spot prices of the commodity or index. However, this correlation is imperfect.

A "roll" process is used to avoid taking physical possession of commodities, selling contracts nearing expiration and buying longer-dated futures contracts. This can sometimes be more expensive due to changes in spot prices and time value in the futures contract, a situation known as "contango."

Before investing in commodity or volatility futures-linked ETPs, it's essential to read the prospectus and consider the product's objectives, risks, charges, and expenses.

Some key risks to consider include:

It's crucial to understand these risks and carefully evaluate the product before investing.

Leveraged ETFs are typically used by day traders speculating on an index or other targeted sets of assets. It's difficult to hold long-term investments in LETFs because the derivatives used for the leverage are not long-term investments.

These ETFs are designed to reset daily, which means they can't build on themselves over time. As a result, traders often hold positions in LETFs for day trading.

The ProShares UltraPro S&P500 (UPRO) ETF holds 77% individual S&P 500 stocks and 8% S&P futures, which is not a long-term investment strategy.

These ETFs are not intended for long-term strategies since they're anchored in techniques for returns within a trading day. If you want ETFs for long-term investing, there are myriad financial products designed for this strategy.

The daily reset period of leveraged ETFs can lead to results different from a simple doubling, tripling, or inverse of the benchmark's average return over the same period. This difference in results can be magnified in volatile markets.

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Leveraged ETFs can be categorized based on their investment objectives and strategies. There are various types of leveraged ETFs, including those that track a specific index, commodity, or asset class.

Some leveraged ETFs aim to deliver a multiple of the daily performance of an underlying index, such as the S&P 500, while others focus on tracking the daily changes of a specific commodity or asset class.

Leveraged ETFs often employ derivatives like futures contracts, forward contracts, total return swaps, and options to achieve their investment objectives. These derivatives can be used to amplify the returns of an underlying asset or to hedge against potential losses.

Here are some common types of leveraged ETFs:

In addition to these types, there are also leveraged ETFs that focus on specific asset classes, such as real estate or cryptocurrencies. These ETFs can provide investors with exposure to a particular market or sector, while also offering the potential for amplified returns.

Overall, the types of leveraged ETFs available can vary widely, and investors should carefully consider their investment objectives and risk tolerance before selecting a particular product.

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