Investors use plenty of tricks in their attempts to beat the overall performance of the stock market. Leveraged exchange-traded funds (ETFs) fit into this category. A leveraged ETF generally tracks a stock market index, industry, or asset class, and uses debt to boost the fund's return. Buying shares in a leveraged ETF poses certain risks, which investors should be clearly aware of before making any investing decisions.
Image Source: The Motley Fool
What is a leveraged ETF?
What is a leveraged ETF?
A leveraged ETF (exchange traded fund), which holds both debt and shareholder equity, uses the debt to amplify the daily return to shareholders. Non-leveraged ETFs, by contrast, hold only shareholder leveraged equity and simply track an underlying index or asset class with the goal of matching that index or asset's performance. Fund managers of leveraged ETFs aim to generate daily returns that are multiples of the performance of the underlying index or asset class with the objective of earning returns that exceed the cost of assuming the debt.
Leveraged ETFs may also use derivatives -- such as options and futures contracts -- to amplify returns. Inverse leveraged ETFs use derivatives to generate the opposite of the daily return of an index or asset class. Investors who expect the value of an index or asset class to decline, much like short sellers, may buy shares in an inverse leveraged ETF. Some inverse leveraged ETFs aim to generate a multiple of the opposite of the daily return of an index or asset class.
Definition Icon
Exchange-Traded Fund (ETF)
An exchange-traded fund, or ETF, allows investors to buy many stocks or bonds at once.
How leveraged ETFs work
How leveraged ETFs work
The easiest way to explain how leveragedfunds work is to provide a few examples. Let's assume that you hold shares in a triple-leveraged ETF that tracks the S&P 500 (SNPINDEX:^GSPC) and that the index loses 20% of its value in a month. Your shares in the leveraged ETF would lose roughly 60% of their value. If the ETF was not leveraged, the value of the S&P 500 would need to rise by about 25% for you to recoup your losses. (If an asset loses and regains value, the regained value represents a larger proportion of the value of the asset at its reduced amount.) But with the triple-leveraged ETF, the S&P's value would need to rise by 50% and the value of your shares in the ETF by 150% to recoup those same losses.
The ProShares Ultra S&P 500 ETF (SSO -3.17%) is a leveraged ETF designed to return two times the daily return of the S&P 500. If the value of the S&P 500 increases by 1% in a day, then the value of this fund rises by roughly 2% after management fees are subtracted. But, if the S&P 500 loses 1% of its value in a day, then the ProShares Ultra S&P 500 ETF declines in value by about 2%.
The ProShares UltraShort S&P 500 ETF(SDS 3.19%) is an inverse leveraged ETF designed to return two times the opposite of the S&P 500's daily performance. If the S&P 500 loses 1% of value in a day, then this fund's value increases by 2%. A value increase of 2% for the S&P 500 results in a 4% value decrease for the ProShares UltraShort S&P 500 ETF.
Because the effects of leverage are compounded over time with leveraged ETFs, the long-term returns generated by these ETFs do not simply mirror the returns of the index or asset class they are designed to track. Periods of volatility can cause leveraged ETFs to severely underperform relative to the asset or index they track. As with the first example above, a triple-leveraged S&P 500 ETF loses 60% when the underlying index only loses 20%. In some rare cases, particularly when derivatives are used, a leveraged ETF can even lose all or most of its value.
Pros and Cons of leveraged ETFs
Pros and cons of leveraged ETFs
Leveraged ETFs are often used by traders making short-term investments. Imagine that a trader expects the price of oil to increase over the course of a few days or weeks. A small position in a leveraged ETF can greatly increase the trader's return if that prediction is correct. If a trader expects oil's short-term price to decline, then owning shares in an inverse leveraged ETF can provide a hedge against potential losses. But, if a trader wrongly predicts an outcome, then the leveraged nature of the ETF amplifies the trader's losses.
These are the main benefits and drawbacks of investing in a leveraged ETF:
Chart by author.| Benefits of Leveraged ETFs | Risks of Leveraged ETFs |
|---|
|
| Leveraged ETFs amplify daily returns and can help traders generate outsized returns and hedge against potential losses. | A leveraged ETF's amplified daily returns can trigger steep losses in short periods of time, and a leveraged ETF can lose most or all of its value. |
| Shares of leveraged ETFs are traded in the open market like a stock. | Some leveraged ETFs are not heavily traded, meaning that your ability to buy or sell shares in a leveraged fund may be constrained. |
| Investing in a leveraged ETF can confer indirect exposure to derivatives contracts. | Because they utilize derivatives to boost returns, leveraged ETFs are less likely to closely track the underlying index or asset. |
| Leveraged ETFs mirror the daily returns of an index or asset with minimal tracking errors. | Leveraged ETFs over the long term do not closely mirror the daily returns of the index or asset they track. |
How to Invest in ETFsExchange-traded funds let an investor buy lots of stocks and bonds at once.
How to Invest in Index FundsIndex funds track a particular index and can be a good way to invest. Get a fast introduction to index funds here.
How to Invest MoneyBefore you put down your hard-earned cash, consider your investment style.
Industries That Thrive During RecessionsSome industries do well when the economy goes south. Here's how to recession-proof your portfolio.
Should a long-term investor buy leveraged ETFs?
Should a long-term investor buy leveraged ETFs?
While leveraged ETFs can technically be held for long periods of time, The Motley Fool does not recommend doing so. The prospect of generating impressive returns in the short term might be tempting, but, in periods of economic decline, leveraged ETFs can lose significant value. Non-leveraged ETFs are a far better option for a long-term investor.
Nicholas Rossolillo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
FAQs
While leveraged ETFs can technically be held for long periods of time, The Motley Fool does not recommend doing so. The prospect of generating impressive returns in the short term might be tempting, but, in periods of economic decline, leveraged ETFs can lose significant value.
Should you invest in leveraged ETFs for long-term? ›
Nearly all leveraged ETFs come with a prominent warning in their prospectus: they are not designed for long-term holding. The combination of leverage, market volatility, and an unfavorable sequence of returns can lead to disastrous outcomes.
What is the best ETF for long-term growth? ›
7 Best Long-Term ETFs to Buy and Hold
| ETF | Assets Under Management | 10-Year Annualized Return |
|---|
| iShares Core S&P Mid-Cap ETF (IJH) | $85 billion | 9.9% |
| Invesco QQQ Trust (QQQ) | $259 billion | 18.6% |
| Vanguard High Dividend Yield ETF (VYM) | $55 billion | 10.1% |
| Vanguard Total International Stock ETF (VXUS) | $69 billion | 4.5% |
3 more rowsApr 24, 2024
A leveraged ETF uses derivative contracts to magnify the daily gains of an index or benchmark. These funds can offer high returns, but they also come with high risk and expenses. Funds that offer 3x leverage are particularly risky because they require higher leverage to achieve their returns.
What is the most active leveraged ETF? ›
ProShares UltraPro QQQ is the most popular and liquid ETF in the leveraged space, with AUM of $21.9 billion and an average daily volume of 67.3 million shares a day. The fund seeks to deliver three times the return of the daily performance of the NASDAQ-100 Index, charging investors 0.88% in annual fees.
Why shouldn't you hold leveraged ETFs long term? ›
Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.
How long is too long to hold a leveraged ETF? ›
The daily rebalancing of leveraged and inverse ETFs creates a situation that for periods longer than a day or two the return of a leveraged or inverse ETF will deviate from the margin account benchmark.
Which ETF has the best 10 year return? ›
Top 10 ETFs by 10-year Performance
| Ticker | Fund | 10-Yr Return |
|---|
| VGT | Vanguard Information Technology ETF | 19.60% |
| IYW | iShares U.S. Technology ETF | 19.58% |
| IXN | iShares Global Tech ETF | 18.20% |
| IGM | iShares Expanded Tech Sector ETF | 17.95% |
6 more rowsHolding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.
Is VOO a good long-term investment? ›
The Vanguard S&P 500 ETF (VOO 1.24%) is one of the best ways to invest in the S&P 500, which has been a pretty smart strategy over the long term. Since 1965, the S&P 500 has produced a total return of 10.2% annualized. The Vanguard ETF has an expense ratio of just 0.03%, so you get to keep most of your gains.
Leveraged ETFs amplify daily returns and can help traders generate outsized returns and hedge against potential losses. A leveraged ETF's amplified daily returns can trigger steep losses in short periods of time, and a leveraged ETF can lose most or all of its value.
Why doesn t everyone buy leveraged ETFs? ›
Because leveraged single-stock ETFs in particular amplify the effect of price movements of the underlying individual stocks, investors holding these funds will experience even greater volatility and risk than investors who hold the underlying stock itself.
Are there 4x leveraged ETFs? ›
BMO has launched the first quadruple leveraged ETN fund that tracks the S&P 500. The fund will trade under the ticker symbol "XXXX" and seeks to generate four time the S&P 500's return on a daily basis. The launch come as bullishness rise among investors and Wall Street predicts more gains to come in 2024.
Are there 5x leveraged ETFs? ›
Longtime ETF analyst Todd Sohn of Strategas Securities said the Leverage Shares 5x Long Magnificent Seven ETP UK:MAG7 appears to be the most heavily levered product available to trade in any developed market, although a seven-times levered index on oil and gas futures exists in Europe.
What is the most volatile 3x ETF? ›
The Direxion Daily Junior Gold Miners Index Bull 3x Shares (JNUG) and the Direxion Daily Junior Gold Miners Index Bear 3x Shares (JDST) are the two most volatile exchange-traded funds of all. Each has a one-year volatility reading of about 170.
What is the most aggressive ETF? ›
The largest Aggressive ETF is the iShares Core Aggressive Allocation ETF AOA with $1.83B in assets. In the last trailing year, the best-performing Aggressive ETF was AOA at 14.42%. The most recent ETF launched in the Aggressive space was the iShares ESG Aware Aggressive Allocation ETF EAOA on 06/12/20.
Is a leveraged ETF worth it? ›
We found that leveraged ETFs in three out of the four categories provide sufficient returns over the long run to justify their costs and risks, and despite persistent tracking-error divergence. We began our research by pulling data on all leveraged ETFs that have been issued in U.S. markets over the past 10 years.
Is it okay to hold TQQQ long term? ›
So when QQQ suffered a 37% drawdown from its November 2021 high, TQQQ was hit with a drawdown of over 82%. To get back to even from there, TQQQ would need to make back over 450%. And as we saw in Figure 1, it still has quite a way to go. You might not yet be convinced of the danger of holding TQQQ over the long term.
Can you invest long term with leverage? ›
They said, “Leveraged ETFs are not suitable for long-term buy and hold.”
