October 15, 2015

What are leveraged ETFs?

Leveraged ETFs are funds that are listed and traded like stocks and are designed to match the performance of a particular index. But, there are two distinct differences:

1. Leveraged ETFs magnify exposure to an index. While a regular ETF will attempt to match the benchmark index's performance 1:1, a leveraged ETF will usually match it 2:1 or 3:1. That means for each $1 you have invested, you have $2 or $3 of exposure to the index, magnifying your potential risk and volatility by 200% or 300%. This additional exposure comes from derivative investments. Leveraged ETFs will often have a significant percentage of their holdings in futures and swaps, and the funds are compounded daily.

2. Leveraged ETFs have daily investment objectives. A leveraged ETF might meet its goal of performing at 200% of the benchmark on each individual trading day, but over time, the fund's performance in relation to the benchmark will likely be significantly different due to the effects of compounding. Investors should monitor the performance of their leveraged ETF investments daily and relate it to their investment strategy and risk tolerance. These investments may, in fact, deliver an opposite return than the benchmark over a period of more than one day.

Inverse ETFs have the same daily goals and magnified exposure as leveraged ETFs, but they aim to perform opposite their benchmark index. For example, if an index goes up 1%, a corresponding 2:1 leveraged ETF would go up 2%, and a 2:1 inverse ETF would go down 2%.

Because of the magnified exposure to the benchmark index, the volatility is magnified in the leveraged funds, and we see stronger up and down swings. And because the percentage movement up or down is affected by compounding, meaning it is based off of the final price from the previous day, it is harder for the leveraged funds to recoup their losses.

As a relatively new investment product, leveraged ETFs provide the investment community a learning opportunity to determine whether these investment vehicles are best suited for short-term, mid-term or long-term investing. Analysts point out that, as in our example above, often the daily movements can be more profitable than multi-day returns, but this type of performance is not guaranteed. Investors should evaluate their personal investment strategy and risk tolerance before deciding whether leveraged or inverse ETFs are the right choice for them.

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