What are leveraged ETFs?
To start with, it’s important to understand that an exchange-traded fund (ETF) is a fund that contains a basket of securities from the index that it tracks. An ETF that tracks the FTSE 100 will contain the 100 stocks in the index, weighted so that when the index moves up or down, the ETF mimics its performance as closely as possible.
Then, there’s the concept of leverage – an investing strategy that uses borrowed funds (debt) to buy listed futures and options or trade with OTC products like spread betting or CFDs to increase the financial returns of price movements.
A leveraged ETF, therefore, is an exchange-traded fund that holds debt and shareholder equity. It uses the debt to amplify potential shareholder returns. Non-leveraged ETFs, on the other hand, only hold shareholder equity. These simply track an underlying asset class or index.
Fund managers in charge of a leveraged ETF aim to generate daily returns that are multiples of the performance of the underlying index or asset. Here, the primary aim is to deliver returns that exceed the cost of the assumed debt. They usually do this using derivatives contracts – such as futures and options – to further amplify returns. Some managers even use derivatives to generate returns if the index or asset class falls in value, for investors who believe an asset is due to fall.¹
An important consideration is that leverage is a double-edged sword – any losses are correspondingly magnified. Investors should consider leveraged ETFs with their eyes wide open. Losses can be far higher than with traditional investments, while standard index-linked ETFs have a reputation for safety.
There are usually transaction costs and management fees to pay too, which can reduce a fund’s return. An expense ratio of circa 1% is about average, though fees can be far higher for select ETFs.