What are Leveraged ETFs?

Leveraged Exchange Traded Funds (ETFs) are one of the newest financial instruments available for trading and investing; introduced in 2006. They are index funds which try to amplify the return from the underlying index using leveraged money. Leverage ETFs keep a constant leverage level, which can be 2:1 (to double the return) or 3:1 (to triple the return).

Unlike trading on margin, which involves paying off of interest on burrowed money, leveraged exchange traded funds use derivatives like index options, index futures and equity swaps to increase or reduce market exposure. They do so in a daily basis, and thus there is no surety of amplified annual returns. For example for a fund that doubles the return, if the index return 1% in one day, the fund value raises 2%; and if returns -1% the fund a return -2%. But as the leverage is constantly adjusted (rebalanced) on daily basis to keep the ratio constant (say 2:1), losses produce bigger effects than profits. For example a 1% loss for 4 days and a 4.1% gain on fifth day will produce no net loss/profit in a normal index ETF performance, but a 0.2% loss in original leveraged ETF value.

The daily rebalancing of leverage results in extra trading, interest and management costs, which can eat up the profit. This make leveraged ETFs unsuitable for long-term profiting. It is advised to analyze the leveraged ETF’s past daily returns with respect to the underlying index before start trading the ETF.

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