Leveraged ETFs

Leveraged exchange-traded funds (ETFs) are a type of security that are similar to a ‘traditional’ ETF, tracking similar indices, industries or asset classes. The main difference is that leveraged ETFs use debt and derivatives (like options or futures contracts) to increase the potential returns (and therefore increase the potential losses). Leveraged funds are sometimes called “Bull” ETFs.

Leveraged ETFs have many pros and cons, with the primary benefit (or downside) being the ‘built-in’ leverage of the fund. Similar to trading in a margin account, when you use leverage or borrowed funds to invest, these funds can increase your potential returns, but also your potential losses. Many leveraged ETFs will target a ratio of 2:1 or 3:1 daily return on equity instead of the 1:1 targeted by the traditional non-leveraged fund.

Important to know: While leveraged funds target 2x or 3x performance of the same underlying assets, these funds may not be exact multiples due to the way they are constructed. This is due to the generally high Management expense ratios (MERs), and other factors involved in how these funds are created by using derivatives. Leveraged funds are generally used by investors who trade or invest with a short time horizon, and a high risk tolerance.

How are leveraged ETFs made?

Fund managers of leveraged ETFs attempt to achieve a targeted 2x, or 3x gain of the underlying index/asset class using a combination of debt, derivatives, and equity.

These funds only target daily performance, and after the effects of long-term leverage, fees, and transaction costs for the fund managers, these funds may potentially underperform if held for a longer period of time.

Leveraged ETFs are generally used as short-term investments by most traders due to these factors.

The pros and cons of leveraged ETFs

As mentioned above, leveraged ETFs are primarily used by traders on a short-term, speculative basis.

Check out the chart below for a high-level overview of some of the risks and benefits of trading leveraged ETFs:

Let’s use an example

This real-life example shows how the returns of a leveraged ETF over longer periods of time can differ significantly from the performance of their underlying index or benchmark:

• Between Sept 8th 2021 and March 8th 2022 a 3x leveraged ETF tracking the Nasdaq-100 index lost 43.41%
• During the same time period, a non-leveraged ETF tracking the underlying Nasdaq-100 index lost 15.34%

Source: TQQQ compared to QQQ’s closing price over the same time period of 09/08/2021 to 03/08/2022.

Securities shown are for illustrative purposes only. Past performance is not indicative of future performance.

This is partially explained by the nearly ~1% MER of the leveraged fund, and some of the other costs and expenses associated with running these funds. This may include: margin interest, transaction costs, options premiums, and more.

The main difference in tracking over long periods of time is due to the leveraged nature of the fund. The example below explains further:

Let’s check out another example:

On Day 1, an index starts with a value of 100, and a 2x leveraged ETF starts at $100. By the end of the day, the index drops 10% closing at 90 points. If the leveraged ETF achieves it’s target, it’s closing price will be $80 (2x the 10% loss of the index).

On day 2, the index rises 10%, increasing the value to 99 points. (90 x 1.1) However the leveraged ETF rises by 20% to only $96 ($80 x 1.2).

On both days, the leveraged ETF performed as intended, and provided a 2x amplification of the indexes returns. However, over a 2-day time period, the index lost 1% (from 100 to 99 points), while the leveraged ETF lost 4% (from $100 to $96).

This means that over a 2-day time period, the losses were 4 times as much as the index itself, and this example highlights the unique risks of holding these types of securities past market close.

Leveraged and Inverse ETFs (explained below) are primarily intended to be short-term investments.