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.
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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 0.84%) 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 -0.93%) 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
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.
Why not invest in 3x leveraged ETF? ›
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.
Does Motley Fool recommend ETFs? ›
The ETF you should consider adding to your portfolio is the Invesco QQQ Trust (QQQ 0.34%). It tracks the Nasdaq-100 index, which contains the 100 largest non-financial companies listed on the Nasdaq exchange. Buying this ETF gives investors access to some of the most tech-savvy businesses out there.
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.
Can 3x leveraged ETF go to zero? ›
This longer-term underperformance results from ill-timed rebalancing and the geometric nature of returns compounding. The author uses the concept of a growth-optimized portfolio to show that highly levered ETFs (3x and inverse ETFs) are likely to converge to zero over longer time horizons.
Is it possible to lose all your money on 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.
Can you lose more than you invest with leverage? ›
Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment. On top of that, brokers and contract traders often charge fees, premiums, and margin rates and require you to maintain a margin account with a specific balance.
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.
Can you lose more than your initial investment in a leveraged ETF? ›
In other words, you could potentially be liable for more than you invested because you bought the position on leverage. But can a leveraged ETF go negative? No. If you own a leveraged ETF you can't lose more than your initial investment amount.
What is the most profitable ETF to invest in? ›
7 Best ETFs to Buy Now
| ETF | Assets Under Management | Expense Ratio |
|---|
| Vanguard Information Technology ETF (VGT) | $70 billion | 0.10% |
| VanEck Semiconductor ETF (SMH) | $16.3 billion | 0.35% |
| Invesco S&P MidCap Momentum ETF (XMMO) | $1.6 billion | 0.34% |
| SPDR S&P Homebuilders ETF (XHB) | $1.8 billion | 0.35% |
3 more rowsApr 3, 2024
In fact, 47% of all such funds have closed down, compared with a closure rate of 28% for nonleveraged, noninverse ETFs. "Leveraged and inverse funds generally aren't meant to be held for longer than a day, and some types of leveraged and inverse ETFs tend to lose the majority of their value over time," Emily says.
Which ETFs beat the S&P 500? ›
Sector ETFs are another way to beat the S&P 500. While no single sector will beat the broad-market index all the time, investing in sector ETFs can pay off. With geopolitical tensions in the world, defense stocks are up this year, and that has made the Global X Defense Tech ETF (SHLD -0.18%) a winner.
How long should I hold Sqqq? ›
The SQQQ is meant to be held intraday and is not a long-term investment, where expenses and decay will quickly eat into returns.
Can 2x leveraged ETF go to zero? ›
Because they rebalance daily, leveraged ETFs usually never lose all of their value. They can, however, fall toward zero over time. If a leveraged ETF approaches zero, its manager typically liquidates its assets and pays out all remaining holders in cash.
Why avoid leveraged ETFs? ›
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.
Is it okay to hold TQQQ long term? ›
TQQQ is one of the largest leveraged ETFs that also tracks the Nasdaq-100. QQQ is perhaps best-suited as a long-term investment for those who want broad exposure to the Nasdaq-100 Index. TQQQ is built for short-holding periods and is best suited for day traders.
What happens if I hold TQQQ long term? ›
Don't go all in and don't buy and hold TQQQ – or any leveraged stocks ETF – “naked” for the long term without a hedge of some sort, because sometimes they simply can't recover from major drawdowns. The last decade has looked great for TQQQ, but don't succumb to recency bias.
Are concerns about leveraged ETFs overblown? ›
By some estimates, returns generate up to 74% less rebalancing by leveraged and inverse ETFs once capital flows are taken into account. As a consequence, the potential for these types of products to exacerbate volatility should be much lower than many claim.
What is the biggest risk associated with leveraged ETFs? ›
The two major risks associated with leveraged ETFs are decay and high volatility. High volatility translates to high risk. Decay emanates from holding the ETFs for long periods.
