A leveraged exchange-traded fund (ETF) is a financial instrument that aims to amplify the returns of an underlying index or asset class through the use of financial derivatives and debt. These ETFs use leverage, typically borrowing capital to increase the exposure to the underlying assets beyond what would be possible with just the initial investment.
Let’s explore how it works:
1. Leverage: Leveraged ETFs use financial derivatives such as swaps, futures contracts, or options to amplify the returns of the underlying assets. For example, a 2x leveraged ETF aims to provide twice the daily return of its underlying index.
2. Daily Reset: It’s important to note that leveraged ETFs usually aim to achieve their leveraged returns on a daily basis. This means that they reset their leverage daily, often at the end of each trading day, to maintain a constant multiple of the daily returns of the underlying index. Due to compounding, the long-term returns of leveraged ETFs may differ significantly from the multiple of the returns of the underlying index.
3. Risk: While leveraged ETFs offer the potential for higher returns, they also come with higher risks. Because of the daily resetting, the performance of leveraged ETFs over longer periods can deviate significantly from the performance of the underlying index, especially in volatile markets. Additionally, the use of leverage magnifies both gains and losses, meaning that losses can be amplified just as much as gains.
4. Suitability: Leveraged ETFs are generally considered to be more appropriate for experienced and active traders who understand the risks involved and are able to closely monitor their positions. They are not typically recommended for long-term buy-and-hold investors due to their complex nature and potential for significant volatility.
Investors considering leveraged ETFs should thoroughly research and understand how they work, their risks, and their suitability for their investment goals and risk tolerance. It’s also advisable to consult with a financial advisor before investing in leveraged ETFs or any other complex financial products.
