What are Leveraged ETFs & How Do They Work?

Leverage is just fancy investor-speak for “getting an advantage through taking on debt.“

Leveraged exchange-traded funds, or ETFs, use the same principle: They borrow money to try to double or triple any movement in their benchmark in a particular day. That means when you win, you win big and when you lose, well, it’s not pretty.

Previously, anyone interested in leveraging ETFs would have to borrow money in a margin account, take out a line of credit or get an investment loan and use that to buy a traditional ETF. To make money, their rate of return would have to exceed the interest on the debt. However, these new products do all the borrowing inside the fund so you don’t have to worry about interest or dealing with a margin call. In other words, you can capture all the gains of a leveraged investments without the possibility of losing anything more than your principle. It’s a lower-risk way to do something pretty risky to begin with.

Pros and cons of leveraged ETFs

Advantages:

• Good alternative to taking out an investment loan since you can’t lose more than you invest and don’t have to deal with margin calls

• Liquid investment, just like any other ETF

• Easy to purchase by searching its ticker on the stock exchange, just like any other ETF

Drawbacks:

• Extensive research and analysis needed

• Leveraged ETFs need to be actively managed due to their higher risk profile

• Leveraged ETFs borrow money through complicated derivative techniques that many people do not understand, and you should invest the time in understanding an investment before buying

What is a leveraged ETF

To understand exactly how leveraged ETFs work, we first have to understand the fundamentals of how a standard ETF uses an index.

You know when you turn on the news and you hear the anchor saying in a slightly panicked tone that the Dow dropped by 100 points? It seems really important but you have no clue what it actually means? Well, all that cable news station is blaring on about is the performance of a group of 30 massive companies in the U.S.—an index titled Dow Jones Industrial Average. It’s not a stock in itself, although it moves up or down based on the performance of the stocks it holds.

There are many more of these indices, each holding a collection of stocks that measures the performance of a particular sector or slice of the financial markets.

There’s no set number of stocks or bonds an index can hold—it can be a handful or hundreds.

You don’t invest directly in an index, but you can invest in ETFs, a financial product that attempts to mimic an index. ETFs do this by buying up all the securities in the index in equal weighting and use the index as a point of reference to duplicate their performance. You can judge if an ETF is doing its job by checking how closely its performance matches its benchmark.

So if the benchmark goes up 5% a year, then the ETF should, too. And if it goes down 5%, then the ETF will fall. Traditional ETFs act don’t try to do better than their benchmark—instead it’s like being taken on a boat ride and rising and falling with the tides.

They simply seek to match a specific index by purchasing and holding the securities in the index they’re trying to duplicate. Like mutual funds they allow investors to diversify through a single holding, because that holding acts like a basket, itself holding multiple securities. Unlike mutual funds, they rarely have human managers making buying and selling decisions and don’t try to reach a performance target. Instead, they use an algorithm to simply duplicate their benchmark without trying to outperform it. They charge a low administrative fee that reflects their hands-off approach.

How leveraged ETFs work

But ETFs proved such a popular financial product that they’ve produced spin-offs, many which have little resemblance to the original. One of these new products are leveraged ETFs, which seek not to match, but to exceed, their benchmark’s daily performance through betting larger, borrowed sums.

Leveraged ETFs can’t really be compared to traditional ETFs. Traditional ETFs are a passively managed, easy method for novice or busy investors to build wealth over decades. Leveraged ETFs are heavily managed, speculative, risky, and usually short-term investments—due to their structure they are most commonly used as a short term investment. The managers get financing and rebalance the securities every morning to reach their goal. To reflect the active administration, fees are much more expensive than traditional ETFs.

Some ETFs even try to triple-leverage your investment, or return 300% of the benchmark’s daily performance. That sounds pretty good until you consider that a benchmark index can easily go down, which means you’ve just amplified any losses by 300%.

Unlike many traditional ETFs, which are suitable for any investor with a low-to-medium risk tolerance, these complex financial products might be better suitable for sophisticated investors who like a thrill and who have money they don’t mind losing.

Should you invest in leveraged ETFs

Top investing professionals, like Warren Buffet himself, recommend the best way to build wealth for retirement is to consistently stash cash in an ETF that tracks around 500 of the largest U.S. companies. That way you’re not placing any bets on the fate of a particular company but rather betting on the U.S. economy itself. The theory is that over the very long term, 30 to 50 years, the economy will have grown, although day to day, and year to year and even decade to decade, movement will vary dramatically. The same does not apply to leveraged ETFs.

By nature, leveraged ETFs are generally seen as short-term investments. Nevertheless, they may have a place in your portfolio if you’re a seasoned investor and fully understand how they work. If you have set aside a specific set of money in your portfolio to “play” with, it may work for you.