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What are leveraged ETFs? ​

Leveraged ETFs are exchange-traded funds designed to amplify the daily returns of an underlying index, typically by a factor of 2x or 3x. This means that a 2x leveraged ETF aims to deliver twice the daily performance of its index, while a 3x leveraged ETF targets three times the daily performance. For instance, if the underlying index rises by 1% in a day, a 2x leveraged ETF should theoretically increase by 2%, and a 3x leveraged ETF by 3%.

However, it’s important to note that leveraged ETFs achieve these returns on a daily basis, not over longer time frames, due to the compounding effect. Over time, this can lead to returns that diverge significantly from the underlying index's long-term performance, especially in volatile markets.

How Leveraged ETFs Work

  1. Use of Derivatives: Leveraged ETFs use financial derivatives like futures contracts, swaps, and options to achieve the targeted multiplier effect. These contracts provide the necessary leverage without requiring the fund to fully invest in all underlying assets.
  2. Daily Rebalancing: Leveraged ETFs rebalance their holdings daily to reset to the target leverage ratio. This daily reset is critical, as it compounds returns based on daily percentage changes rather than long-term gains or losses.
  3. Compounding Effect: Since leveraged ETFs rebalance daily, the effects of compounding over time can cause the fund’s returns to deviate from the index. In trending markets, this can lead to amplified returns, but in volatile or fluctuating markets, it can result in losses over time, even if the index itself has not significantly changed.
    • Example of Compounding: Imagine an index that gains 10% one day and loses 9.09% the next, returning to its initial value. A 2x leveraged ETF would gain 20% the first day but lose 18.18% the second day, resulting in a small net loss despite the index returning to its starting level.

Types of Leveraged ETFs

  • Bull (Long) Leveraged ETFs: These funds target positive multipliers, such as 2x or 3x, of the daily return of an index.
  • Bear (Inverse) Leveraged ETFs: These target negative multipliers (e.g., -2x or -3x) and are used by investors who want to profit from the index’s decline.

Advantages of Leveraged ETFs

  1. Potential for Amplified Returns: When markets trend in one direction, leveraged ETFs can yield significantly higher returns than non-leveraged ETFs.
  2. Short-Term Trading Tool: These ETFs are popular among day traders and short-term investors seeking to capitalize on specific daily market movements.
  3. Simplicity for Short-Term Leverage: Leveraged ETFs allow for amplified exposure without the need to use margin accounts or borrow capital, simplifying leveraged strategies for retail investors.

Risks and Considerations of Leveraged ETFs

  1. Volatility Decay: Leveraged ETFs can experience significant losses in volatile markets, even if the index remains flat. The daily resetting and compounding effect mean that a choppy market can erode returns.
  2. High Fees and Costs: Leveraged ETFs usually have higher management fees due to their use of derivatives and daily rebalancing, which increase trading costs.
  3. Tracking Error Over Time: Leveraged ETFs are not designed for holding periods longer than a day in most cases, as their returns may diverge significantly from the index over weeks or months.
  4. Market Knowledge Requirement: Leveraged ETFs are complex and can lead to unexpected losses for investors unfamiliar with the effects of compounding and volatility on returns.

When to Use Leveraged ETFs

Leveraged ETFs are generally suited for short-term trading strategies or for investors looking to make tactical moves based on a specific daily market view. They are not typically recommended for buy-and-hold investors or those looking for long-term index exposure, as the risks and effects of compounding can outweigh potential benefits.

Summary

Leveraged ETFs provide a way to amplify daily returns of an index by 2x, 3x, or more, using derivatives and daily rebalancing. They are best for short-term strategies, given the impact of compounding and potential for tracking errors over time, and are associated with higher risks, costs, and volatility decay.
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