Traders previously had to utilize options or futures contracts to gain leveraged returns in the markets. Leveraged exchange traded funds that provide geared exposure to underlying markets have simplified the task, but investors need to thoroughly understand how the ETFs work and the risks involved.
To start off, leveraged ETFs are securities that trade on an exchange and can be bought and sold throughout the day, like a regular stock, writes Mark P. Cussen for Investopedia.
However, unlike traditional index ETFs, leveraged funds utilize derivatives to achieve their exponential returns. The derivatives include instruments like swap agreements, futures and forward contracts, and put and call options.
For instance, a double, 2x or 200% leveraged ETF’s price would increase or decrease twice as much as the price of the underlying non-leveraged market or index. If the underlying index rises 2% in a day, the leveraged ETF would gain 4%.
Additionally, there are a number of leveraged ETFs offering triple or 300% leverage, which would rise or fall three times as much as the underlying market. Alternatively, there are also leveraged inverse ETFs that move in the opposite direction to their benchmarks – the inverse ETFs would fall in price at its specified exponential rate when the benchmark rises and vice versa.
Leveraged ETFs that move exponentially to the benchmark are considered long or bullish funds while those that move inversely are called short or bearish products.
Traders considering these ETFs should be aware that the inverse and leveraged products typically try to achieve their objective on a daily basis, and due to compounding of daily returns, the performance of the ETFs may diverge from the target return over extended periods, especially during volatile market conditions.
“When it comes to leveraged fund products that track daily results, their returns over time are the product of a series of daily returns,” according to Direxion. “They are not the fund’s leverage point multiplied by the cumulative return of the index for periods greater than a day. During periods of high volatility where markets lack a directional trend, returns can be impacted in a negative way should the funds be held for long periods.”
Compounding can affect leveraged ETFs differently in varying market conditions. For example, in an upward-trending market, compounding can result in long-term returns that are greater than the sum of the individual daily returns, according to ProShares. In a downward-trending market, it can show long-term results that are less negative than the sum of individual daily returns. However, the long-term results are less than the sum of the individual daily returns in volatile market conditions. [Leveraged ETFs Gain Popularity in Trending Markets]
For more information on geared products, visit our leveraged ETFs category.