What Is a Leveraged ETF and Its Associated Risks?

A leveraged ETF is a type of exchange-traded fund that uses financial derivatives and debt to amplify the returns of a specific index or asset class. This means that the fund's value can change at a rate that is multiple times that of the underlying asset.

Leverage can be a double-edged sword, and it's essential to understand the associated risks. According to the article, a leveraged ETF's value can change by up to 200% in a single day, making it a high-risk investment.

The article highlights that leveraged ETFs are not suitable for long-term investors, as their value can fluctuate wildly over time. This is particularly true for investors who are not comfortable with the possibility of losing a significant portion of their investment.

Leveraged ETFs are designed to be traded actively, with the goal of profiting from short-term market movements. However, this also means that the fund's value can drop rapidly if the market moves against it.

A leveraged ETF is a type of exchange-traded fund that amplifies the gains or losses of an underlying index. It's like a supercharged version of a traditional ETF.

Leveraged ETFs use options contracts to amplify the return of an underlying index, and they can offer returns that are two, three, or even 10 times the return of the index. For example, the ProShares UltraPro QQQ (TQQQ) is a three-times leveraged ETF that tracks the Nasdaq 100.

These funds can be found in various sectors, including equity indexes, single stocks, fixed income, commodities, and currencies. They're not just limited to a specific type of investment.

Some examples of leveraged ETFs include the ProShares Ultra S&P 500 (SSO), which is a two-times leveraged ETF, and the GraniteShares 2x Long NVDA Daily ETF (NVDL), which is based on the chipmaker NVIDIA (NVDA).

Leveraged ETFs can be a double-edged sword, offering amplified returns but also exposing investors to significant risks. In trending markets with low volatility, a Direxion Daily Leveraged 3X Bull Fund may outperform the benchmark index, but this is not always the case.

In volatile markets with no clear trend, daily rebalancing can be detrimental to the fund's performance. This is because the fund responds to gains by increasing exposure, and to losses by decreasing exposure, resulting in a pattern of decay in longer-term returns.

Market price variance risk is another concern, as the market prices of shares can fluctuate in response to changes in net asset value and supply and demand. This can lead to premiums or discounts, making it difficult to accurately predict the share price.

Direxion Daily Leveraged ETFs can respond to gains by becoming more aggressive and respond to losses by becoming more defensive, which can be an advantage in directional markets but a disadvantage in volatile markets lacking direction.

In trending markets with low volatility, the performance for periods longer than a day may exceed the return of the benchmark index, multiplied by the stated exposure level of the portfolio. This is because the fund's net assets rise with the favorable market fluctuation, and the fund must respond by increasing its exposure to the benchmark index.

If the benchmark index moves in a direction favorable to the fund in a linear trend for a period greater than one day, the fund's gain for the period may be larger than the cumulative benchmark index return multiplied by the fund's stated multiple. For example, if the benchmark index moves up for a Bull Fund, the fund's gain may be larger than the cumulative benchmark index return multiplied by the fund's stated multiple.

However, if the benchmark index moves in a direction unfavorable to the fund in a linear trend for a period greater than one day, the fund's losses for the period may be smaller than the cumulative benchmark index return multiplied by the fund's stated multiple. For example, if the benchmark index moves down for a Bull Fund, the fund's losses may be smaller than the cumulative benchmark index return multiplied by the fund's stated multiple.

In volatile markets that exhibit no clear trend or direction, the impact of daily rebalancing can be harmful to the performance of leveraged ETFs over time. The fund responds to gains by increasing exposure to the benchmark index, and responds to losses by decreasing exposure each day, which can cause the decay of the longer-term returns of the fund.

Market volatility can lead to a phenomenon known as "volatility drag", where the actual portfolio growth trails the arithmetic return. This is because greater volatility leads to a larger gap between the geometric return and the arithmetic return, resulting in a loss of performance over time.

Daily rebalancing can also cause the fund's exposure to fluctuate wildly, resulting in a loss of performance over time. For example, if the index loses 10% today and ends up at $90, it must climb by 11.1% tomorrow to get back to where it started, resulting in a loss for the ETF investor.

Investing in leveraged and inverse products can be a high-risk endeavor, and it's crucial to understand the risks involved.

These funds are typically much more expensive to hold than other ETFs.

The daily calculation and reset of these funds can cause short-term capital gains, making them less tax efficient.

They are taxed at the same level as ordinary income, which can be a significant drawback for investors.

A Leveraged ETF works by using derivatives, such as futures or options, to amplify investment returns.

These ETFs aim to provide a multiple of the daily performance of the underlying index, but they can also result in significant losses if the market moves against the investor.

Leverage can be a double-edged sword, as it can amplify both gains and losses.

A 2x ETF, for example, aims to return twice the daily performance of the underlying index, but it can also lose twice the daily value if the market declines.

Beta is a measure of a security's or portfolio's volatility in relation to a target index, with a beta of more than 1.00 indicating higher volatility.

You may have noticed that some investments are riskier than others. This is where beta comes in – it helps you understand how much risk you're taking on.

A counterparty is a financial institution that serves as the contracting party in an over-the-counter securities transaction, and counterparty risk refers to the risk of monetary loss if the counterparty encounters difficulty meeting its obligations.

Counterparty risk is a real concern, especially in the world of finance. It's essential to understand the risks involved when dealing with counterparties.

The Intraday NAV (INAV) is used as a reference for an ETF's underlying value during trading hours, and it's essential to calculate INAV before purchasing an ETF to determine if you're buying it at a premium or discount.

Calculating INAV before buying an ETF can save you from making costly mistakes. It's always better to be informed.

The secondary market is where existing securities are traded, and new ETF shares are created in the primary market in large lots called creation units by Authorized Participants.

The secondary market is a crucial part of the financial system, allowing investors to buy and sell existing securities.

Leveraged and inverse ETPs employ complex strategies involving derivatives, primarily futures and swap contracts.

These funds are designed to provide a multiple of an index's performance over a specified time, usually just one day.

A 2x leveraged ETP, for example, aims to deliver a 4% return if the index rises 2%.

Inverse ETPs, on the other hand, attempt to deliver multiples in the opposite direction, so if the index rose 2%, a 2x inverse ETP would generate a negative 4% return.

By design, these funds amplify a portfolio's risk profile, making them potentially unstable over longer periods.

Investors who hold leveraged and inverse ETPs for longer than the reset periods stated in their prospectuses may be surprised to discover their returns are nowhere near the return on the underlying index.

These funds are not designed to be held longer than a single day, and investors who use them as intended are likely to be experienced traders.

Direxion Daily Leveraged ETFs use derivatives, such as swaps or futures, to gain exposure to indexes and sectors. This allows them to magnify returns, but also increases risk and volatility.

For example, a 2X ETF will provide $2 of the performance of the benchmark for every dollar invested, which means 200% of the risk and volatility. This can be a double-edged sword, as it also means amplifying losses.

Direxion ETFs have a daily rebalancing cadence, which can lead to buying high and selling low, increasing transaction costs and volatility. This is because managers must buy more derivatives to increase their notional exposure when the index appreciates, and sell derivatives when the index loses.

In contrast, ProFunds UltraBull got off to a rough start with some of the worst possible timing luck, and amplifying large losses can mean a long journey back up.

Direxion Daily ETFs are designed to provide a unique investment experience. They offer a way to magnify or inverse exposure to the returns of their benchmarks for a single day.

For 2X and 3X ETFs, each dollar invested provides $2 or $3 of the performance of the benchmark, which means 200% or 300% (or -200% or -300% for leveraged Bear Funds) of the risk and volatility.

Direxion Daily Leveraged ETFs seek to magnify or provide inverse exposure to the returns of their benchmarks for a single day. This means that their returns for periods greater than a day are a product of the compounded daily leveraged returns during the period.

To achieve this, Direxion Daily Leveraged ETFs invest in derivatives such as swaps or futures, which provide the ability to gain exposure to respective indexes and sectors without the need for full dollar-for-dollar investment.

The Bull Funds generate between 10% and 100% of their requisite exposure level from equities and the remainder from derivatives.

ProFunds UltraBull got off to a rough start with some of the worst possible timing luck, making it a challenging investment to recover from.

The fund's leverage can amplify large losses, leading to a long journey back up, even with a long enough horizon. This means investors are still incurring a major opportunity cost.

The fund's daily rebalancing adds to its issues, as managers must buy more derivatives to increase notional exposure and maintain leverage, deploying money into an expensive market and selling in an already-falling environment.

Transaction costs run high with the ETF's frequent rebalancing, eating into returns.

Some Direxion ETFs and ProFunds have closed due to poor performance, but not all of them have been delisted. Investors should be aware that some of these funds have used a reverse share split to prolong their existence.

A reverse share split exchanges multiple lower-priced shares for a new, single share with a higher price, leaving the total value of the investment unchanged. This technique raises the share price, avoiding delisting due to penny stock status.

Investors will see a higher share price in their accounts, but the number of shares they own will decline after a reverse share split. This is exactly what happened with some leveraged and inverse ETPs that were trending toward nothingness.

If you're still unsure about leveraged ETFs, you're in the right place.

Direxion offers a range of investment products, including leveraged ETFs.

These products can be a bit complex, so it's natural to have questions.

Direxion has a dedicated team to help answer your questions about their investment products.

If you're looking for answers to frequently asked questions, you can find them on Direxion's website.

Daily leveraged ETFs respond to gains by becoming more aggressive and to losses by becoming more defensive, which can be an advantage in directional markets but a disadvantage in volatile markets lacking direction.

These funds' performance can be significantly different from their stated objectives over the long term.

A daily leveraged fund's exposure is a product of its target magnification and its net assets, which means favorable moves in the benchmark index push net assets higher, resulting in an increase in exposure by a multiple of the gain in its net assets.

Unfavorable moves in the benchmark index lead to a decline in net assets, resulting in a reduction of exposure in an amount which is a multiple of the decline in the net assets.

Leveraged ETFs are best used as short-term trading vehicles, not long-term buy-and-hold positions.

Daily rebalancing can increase the volatility of the return stream, recognizing every gain or loss by the index.

Transaction costs run high with the ETF's frequent rebalancing, and these ETFs typically come with high fees.

The higher the leverage, the longer it will take a fund to recover from large losses, making it a long journey back up.