Leveraged ETFs: An Explainer

What is Leverage? Leverage is the process of getting exposure to a financial asset using borrowed cash. With leverage, it is possible to expose oneself to a much larger value of a financial instrument than possible otherwise. In a typical brokerage account, active traders usually have access to leverage in the form of margin money. The trader posts a margin, anywhere between 10%-50% of the value of the instruments she intends to buy.

Leverage in the capital markets:

Leverage in the equity markets is common across the world. More specifically leverage is widely used in futures and options markets. In fact, almost all futures market speculation is done on margin, hence magnifying the potential gains and losses. For example, if a trader posts a $10 margin to buy $100 worth of soybean in the futures market, he is said to be levered 10 times. If the soybean prices move 10%, the trader has doubled his money. However, an equivalent movement in the opposite direction can wipe out all the capital. In the futures market, the trades are marked to market daily. This means any gains would accrue to the trader and any losses would involve posting additional margin.

In the equity markets, brokers provide margin to clients who meet certain requirements like account size. This form of leverage basically involves borrowing funds from the broker. The broker charges a small interest on the loaned funds.

Leveraged ETFs:

The world of leveraged ETF differs from traditional leverage in the sense that the buyer of the ETF does not directly use margin. Neither are borrowing funds involved. The ETF itself is built in a way that a portion of the underlying assets is invested through leverage. This is achieved using options along with underlying holdings. Instead of tracking an index, the ETF aims to magnify the returns of the index through leverage. Hence it is possible to get two-times or three-times the exposure to the underlying index.

Leveraged ETFs are available as 2X or 3X instruments on both the long side and short side. A short ETF is also known as an inverse ETF. An inverse ETF goes down when the market is up and vice versa, with the leverage boosting the inverse performance.

For example, a 2X leveraged ETF on the S&P 500 would magnify the S&P performance by a factor of 2. Say the index goes up 2% on a day, the ETF would be up 4%. More importantly, the leveraged ETFs are daily settled and hence compound over a period. For instance, if the index returns in a particularly strong bull market for 5 consecutive days are: 2%, 2.5%, 2.4%, 3%, 5%. These would generate a weekly return of 15.78%. With a leveraged ETF, the same numbers would result in a weekly performance of 33.48%, slightly more than double un-leveraged returns. This is due to the beauty of compounding. But the returns are magnified in a down market as well. So, it is possible to lose large amounts in the case of a correction. An inverse ETF would exactly be a reverse of the above example. However, an inverse leveraged ETF would be useful in the case of a correction in the market.

An example is summarised in the following table:

Both the leveraged and inverse ETFs are typically used to take advantage of short-term market conditions. Long-term investors with a buy-and-hold strategy have little to gain from leveraged ETFs.

Let’s summarise the Pros and cons of leveraged ETFs:

Investment Options:

Leveraged ETFs are available on both the major indices S&P 500 and Nasdaq 100. They are also available on certain sectors such as semiconductors and financials, for example.

Some of the popular leveraged ETFs are ProShares UltraPro QQQ (TQQQ) which offers a 3X long leverage on the Nasdaq 100,  ProShares Ultra S&P 500 (SSO), offering a 2X long leverage on the S&P 500, Direxion Daily Semiconductor Bull 3x Shares (SOXL), which gives a 3X long leverage on a semiconductor index, ProShares UltraPro Short QQQ (SQQQ), an inverse ETF providing 3X short leverage on the Nasdaq 100, and ProShares Ultra VIX Short-Term Futures ETF (UVXY), a tool for sophisticated strategies that use the volatility index (VIX). The UVXY is a 1.5X leverage on the VIX index.

Source: Morningstar