If you’ve ever tried your odds at an electronic slot machine, you’ll recognize the maximum bet feature. With the click of a button, you increase the number of bets placed per pay line, such that an innocent gamble on a penny slot machine balloons into a multidollar wager.
Magnifying returns is appealing to bettors beyond the casino. In the stock market, traders try to achieve similar results via different means. Leveraged exchange-traded funds offer the potential for amplified returns on investments that track underlying indexes like the Standard & Poor’s 500 index or Dow Jones Industrial Average.
Traders malcontent with simply betting that a particular group of stocks will go up trade leveraged ETFs in the hope of doubling or tripling their returns. Sounds great, but of course there’s a catch — and it’s a doozy. Losses also are magnified by the same degree.
Leveraged ETFs are tools for short-term traders to place speculative bets — key word: bets — and generally don’t make sense for long-term investors. Here’s what you need to know about these investments.
What leveraged ETFs are
Leveraged ETFs are similar to other types of ETFs in two important ways. First, they let investors gain exposure to a basket of multiple securities that’s been neatly packaged as a single asset. Second, they’re designed to track the performance of an underlying index. (Need to back up? Learn more about ETFs.)
Of course, other important distinctions make leveraged ETFs unique. As the word “leveraged” implies, these investments use debt and financial derivatives — securities whose prices are derived from underlying assets — to amplify returns. That level of magnification is predetermined; currently available ratios are 2:1 or 3:1, which means a $1 investment will result in $2 or $3 worth of exposure to the underlying index.
These investments aren’t for the faint of heart because losses are amplified in just the same way as returns.
Leveraged ETFs have been around for more than a decade, and there are more than 140 such products. These ETFs are common offerings at major online brokerages and often bear names to indicate they’re leveraged. Look for words like “ultra” or “daily” or specifications of the multitude of leverage such as 2x or 3x.
How leveraged ETFs work
Leveraged ETFs typically have daily investment objectives, so they’re better suited for investors who plan to keep close tabs on the market. These investments aren’t for the faint of heart because losses are amplified in just the same way as returns.
To understand how these products work in real life, consider one of the largest leveraged ETFs by assets: the ProShares Ultra S&P 500 ETF. This fund is designed to provide two times (2x) the daily performance of the S&P 500 Index, before fees and expenses.
Say the S&P 500 goes up 1% on a given day; this leveraged ETF is designed to provide a return of 2%. But the same is true if the market goes down 1%; there’s a 2% loss on this investment.
The same logic applies to leveraged ETFs with a 3:1 ratio. If the underlying index moves 2%, the potential gains and losses are 6%. For now, a triple (3x) magnitude is the maximum allowed for leveraged ETFs. The Securities and Exchange Commission appears to have had second thoughts about whether the investment community needs 4x leveraged ETFs. After initially approving some funds, it halted proceedings in May 2017 pending further review.
Why leveraged ETFs are risky
Beyond the potential for magnified losses, leveraged ETFs are risky because they’re designed for short-term speculative bets — and traders holding them for longer durations, even a few days, can really get burned.
Most of these funds “reset” on a daily basis, meaning they’re designed to achieve objectives for one day — but not longer. Beyond that one day, performance can differ significantly from that of the underlying index. The following scenario illustrates hypothetical returns over a three-day period, when an index is up slightly but a leveraged ETF is down.
2x leveraged ETF return
2x leveraged ETF level
Because of the compounding effect associated with the daily reset, the longer-term performance of leveraged ETFs is more unpredictable. If you hope to make a short-term bet on a leveraged ETF and the trade doesn’t go as planned — namely, the index falls — holding onto it a few days more will amplify your losses. And importantly, the scenario above doesn’t account for related fees such as trading costs (commission fees) and the expense ratio (management fees), which will cut into any potential profit.
The prospectus for the aforementioned ProShares Ultra S&P 500 ETF spells out such risks: “For periods longer than a single day, the fund will lose money when the level of the index is flat, and it is possible that the fund will lose money even if the level of the index rises. Longer holding periods, higher index volatility and greater leverage each exacerbate the impact of compounding on an investor’s returns.”
Investing in the stock market is inherently risky, but these investments carry additional risks, especially for long-term investors. The SEC, as well as several online brokerages, also clearly outline the risks of investing in leveraged ETFs.
» Intrigued by traditional ETFs? Check out NerdWallet’s picks of best brokers for ETF investors.
If you still feel inclined
While many long-term investors will be deterred, if you’re intent on buying and selling leveraged ETFs, tread carefully. Keep in mind the following:
- Understand the investment. Read the prospectus for the leveraged ETF you’re considering before you invest to ensure you understand how it’s constructed, what fees you’ll face and, of course, the risks of investing.
- Are you ready to be a day trader? Because leveraged ETFs aren’t designed for buy-and-hold investors, you’ll need to have a grasp on the risks associated with day trading.
- Don’t lose your shirt. As with any speculative investment, make sure you keep the size of such investments to a minimum — an amount you’re OK with losing. Leveraged ETFs are a fancy type of gambling, and you don’t want to risk a big chunk of your portfolio on them.
- Know when to walk away. As the example illustrated, leveraged ETFs lose money even when the performance of the underlying index is essentially flat. If you get burned on your bet, admit defeat and liquidate before your losses increase.