Small Cap Leveraged ETFs Explained

Small cap leveraged ETFs are designed to amplify the returns of small cap stocks, but they can be riskier than their unleveraged counterparts.

These ETFs use debt to amplify their returns, which means they can lose more money than the underlying stocks if the market moves against them.

The leverage factor is typically 2x or 3x, meaning the ETF's value will move twice or three times as much as the underlying small cap index.

This can be beneficial for investors who want to amplify their returns, but it's crucial to understand the risks involved.

Small cap stocks are already riskier than large cap stocks, and adding leverage to the mix can increase the potential for losses.

Investors should carefully consider their risk tolerance and financial goals before investing in small cap leveraged ETFs.

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An ETF, or exchange-traded fund, is a security that tracks the performance of an underlying asset, such as an index or stock. It's like a basket that holds a bunch of individual stocks or assets, allowing you to invest in a diversified portfolio with just one security.

A traditional ETF tracks its underlying asset on a one-to-one basis, meaning its performance is directly tied to the performance of the asset it's tracking. For example, if the Nasdaq 100 Index goes up 2%, a traditional ETF will also go up 2%.

Leveraged ETFs, on the other hand, use financial derivatives and debt to amplify the returns of their underlying assets. This means they can potentially earn more than the traditional ETF, but they can also lose more.

Some leveraged ETFs track single stocks, while others track indexes like the Dow Jones Industrial Average. They're available for most major indexes, and they can be a powerful tool for investors who want to amplify their returns.

Here are some common types of derivatives used in leveraged ETFs:

These derivatives allow leveraged ETFs to generate returns through a method called synthetic replication, which is generally more efficient than borrowing to buy the securities of the benchmark.

Small cap leveraged ETFs track a specific index of small-capitalization companies, which can be a great way to gain exposure to this market segment. The Russell 2000 Index, for example, measures the performance of approximately 2,000 small-capitalization companies.

One of the key characteristics of the Russell 2000 Index is that it's based on a combination of market capitalization, which is a key factor in determining the index's constituents.

The Russell 2000 Index is also a subset of the larger Russell 3000 Index, which includes even more companies.

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In terms of pricing and performance, let's take a look at some key statistics for the TNA and TZA funds. The Net Expense Ratio for both funds is 1.08%, but if we exclude Acquired Fund Fees and Expenses, it would be 0.91% for TNA and 0.90% for TZA.

Here are some key performance metrics for the TNA and TZA funds over the past few years:

It's worth noting that short-term performance is not a reliable indicator of a fund's future performance. The funds' adviser, Rafferty Asset Management, LLC, has entered into an Operating Expense Limitation Agreement to waive or reimburse expenses to keep the Net Expense Ratio below 0.95%.

A 2x leveraged ETF aims to deliver twice the daily return of an underlying index through a combination of financial derivatives and debt.

These funds rebalance their portfolios at the end of each trading day to maintain the 2x leverage ratio. This rebalancing process involves adjusting positions in futures, swaps, and other financial instruments to ensure the desired leverage is achieved.

The daily adjustment is crucial because it means that the 2x leverage effect applies strictly to daily returns. Over longer periods, the impact of compounding can cause the ETF's performance to deviate significantly from twice the return of the underlying index, especially in volatile markets.

Leverage in LETFs can come from borrowing, or from derivatives like forward contracts, futures contracts, total return swaps, and options.

Here are some key points to note about these derivatives:

Volatility is a major risk associated with small cap leveraged ETFs. Daily resetting can compound these effects, leading to substantial gains or losses from even small market movements.

To mitigate these risks, it's essential to diversify your investments and spread risk across your portfolio. This means allocating a responsible position size that aligns with your overall strategy and risk tolerance.

Stop-loss orders can also protect investors from facing amplified losses. These orders automatically sell shares when they fall to a certain price level, which can be set at a predetermined price while planning for the risk and investment size as a proportion of the overall portfolio.

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Leveraged ETFs come with higher fees than non-leveraged ETFs, often with expense ratios of 1% or more.

These fees are due to the premiums, fees, and interest paid on the derivatives and for margin costs.

Many LETFs have higher fees than trading on margin, which involves a broker lending money to a customer. This can carry fees of 3% or more on the amount borrowed.

Short selling, which involves borrowing shares from a broker to bet on a downward move, can also be expensive. Using margin to buy stock can become similarly costly.

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.

Here's a comparison of some of the costs associated with LETFs and margin trading:

These costs can add up quickly, making it essential to carefully consider the fees associated with LETFs before investing.

2x Leveraged ETFs can be very volatile, with even small market movements triggering substantial gains or losses.

Daily resetting can compound these effects, making it essential to closely track these investments.

Stop-loss orders can help limit potential losses, but they should be set at a predetermined price while planning for the risk and investment size as a proportion of the overall portfolio.

Diversifying your investments is crucial to spread risk, and you should carefully plan the exposure of your portfolio.

A responsible position size that aligns with your overall strategy and risk tolerance is also vital in managing risk when investing in 2x Leveraged ETFs.

By using stop-loss orders and diversifying your investments, you can protect yourself from amplified losses and maintain a balanced portfolio.

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Small cap leveraged ETFs require a tailored investment approach. This is because some trading strategies and investor profiles are better suited for buying and selling these types of ETFs.

Investors with a high risk tolerance may find small cap leveraged ETFs appealing, especially if their portfolio planning includes aggressive growth goals. Potential investors should take note of these characteristics and compare them with their own portfolio planning, goals, and risk tolerance.

A key consideration is the investor's ability to stomach volatility, as small cap leveraged ETFs can be highly volatile.

Small cap leveraged ETFs offer a range of options for investors looking to amplify their returns.

The ProShares UltraPro Short SmallCap600 ETF (SQQQ) is a popular choice for shorting the small cap market. It uses a combination of leverage and inverse strategies to deliver up to 3 times the inverse daily performance of the Dow Jones U.S. Small Cap Total Stock Market Index.

Investors can also consider the Direxion Daily Small Cap Bull 3X Shares (TNA) for a leveraged long position in the small cap market. This ETF seeks to deliver 300% of the daily performance of the Russell 2000 Index.

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The Dimensional U.S. Small Cap ETF (DFAS) is a great option for investors looking to diversify their portfolio. It has a long history, with its actively managed fund dating back to December 1998.

DFAS has been an ETF since June 2021, and it has a solid track record of performance, with an annualized total return of 9.4% through September 30, 2024. This is nearly 90 basis points higher than its benchmark, the Russell 2000.

The fund's goal is to achieve long-term capital appreciation while minimizing federal income taxes on returns, which is impressive considering its low expense ratio of 0.26%. This is a key benefit for investors who want to keep costs low.

DFAS has a well-diversified portfolio, comprising roughly 2,000 companies with a weighted average market cap of $3.8 billion. Its top 10 holdings account for just 3% of its net assets, indicating a low concentration of risk.

Here are the key facts about DFAS:

The fund's valuation metrics are also attractive, with below-category average price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S) ratios. This suggests that DFAS is a good option for investors looking for a value-oriented investment.

Small cap leveraged ETFs offer a unique investment opportunity, but it's essential to understand the pros and cons before diving in.

One of the biggest advantages of small cap leveraged ETFs is the potential for significant gains that exceed the tracked index or assets.

Investors have a wide variety of securities to trade using LETFs, making it easier to diversify their portfolios.

However, LETFs can also lead to significant losses that exceed the tracked index or assets, which can be devastating for investors.

Higher fees and expense ratios compared with traditional ETFs can eat into your returns, so it's essential to factor these costs into your investment decision.

Small cap leveraged ETFs are not long-term investments, as their performance can change rapidly due to daily compounding.

Here are some key pros and cons to consider: