The exchange traded fund universe is constantly expanding and fund providers have crafted increasingly complex products. Leveraged ETFs have attracted some controversy, and potential investors should understand how these products work, including daily resetting and the impact of compounding returns.
The vast majority of of fund investors do not understand how leveraged products operate, says Felix Salmon for SeekingAlpha. Leveraged ETFs have readily accessible prospectus sheets that explain the strategy, but investors are still holding on to these funds for periods much longer than one day, the blogger says.
Salmon remarks that most investors are applying simple notions gleaned from stocks and applying them to leveraged ETFs. He states that investors are better off without leveraged ETFs since a margin account could serve the same purpose.
Nevertheless, leveraged/inverse ETFs do serve a purpose for intraday traders. Leveraged and inverse ETFs are funds that aim to magnify the daily moves of the market. In a short double-leveraged fund, if the index goes up, then the fund is designed to go down twice that amount, before fees and other costs. In a long leveraged fund, if the index goes up, the fund doubles that. The same principle applies when you’re talking about triple-leveraged ETFs, too.
But if held for more than a day, the leverage may not line up exactly over longer periods, especially in volatile markets.
These funds can be appealing to investors as a hedge against any potential losses. Say you have a holding but don’t really want to sell it and you think the market is due for a short-term correction, then a leveraged or inverse ETF can be used as a hedge.
They can also be used to capitalize on market movements. If an investor believes the market is due for a nice run, a leveraged ETF could be used, although this is an aggressive trade. And as the financial crisis showed, leverage can be a dangerous thing. [What About Leveraged and Inverse ETFs?]
For more information on leveraged funds, visit our leveraged ETFs category.
Max Chen contributed to this article.