Should You Invest in Leveraged ETFs?

If you've been watching the stock market for any amount of time, the odds are high that you have come across something called a leveraged exchange-traded fund (ETF). An ETF bundles stocks into shares and is traded under a ticker symbol. They are bought and sold throughout the day at prices that might be greater or less than the net asset value.

A leveraged ETF uses borrowed money, futures, and swaps to increase the returns of an index, commodity, or other types of investments. They greatly increase the risk that comes with ETFs and are not recommended for beginner investors.

What Is a Leveraged ETF?

For as long as stock markets have been around, people have wanted to bet they could beat them. Someone always believes they can predict the price of an asset and win big if they turned out to be correct. In older, more simple times, this meant you had to buy stock on margin. Today, there are more choices; mutual funds have been around for some time, and ETFs first hit the markets in the 1990s.

Leveraged mutual funds made entry to the market in the 1990s as well. To achieve the same thing as a leveraged ETF at that time, you would have had to work through a hedge fund. These were most often set up as a limited partnership.

Someone always figures out a way to try to make more money with new investments. The first leveraged ETFs showed up in 2006 when the folks on Wall Street used the fairly new ETF concept and created a super-leveraged security known as the leveraged ETF.

ETFs are built around an underlying benchmark, index, or commodity to make money on price changes throughout a trading day. Leveraged ETFs use borrowed money, futures, and swaps to try and amplify these daily price movements. Some designs try to create positive amplification, while others try to create negative amplification (the latter being a so-called "short ETF," alluding to selling a stock short).

How Does a Leveraged ETF Work?

A 3x leveraged ETF could use stocks listed on the S&P 500 index to create three times the returns or three times the loss. The broker might use debt and equity or cash to buy stocks for the ETF. The debt allows the broker to purchase an expensive stock, pay off the debt with the return and new value of the stock if it grows, and pocket the rest.

Here's how debt works to amplify returns: Say you borrow $1,000 at a 4% interest rate. You use that money and $100 of your own funds to buy a stock. You have $1,100 invested at that time. If the price goes up 1% in one day, the stock is worth $1,111. You could pay off the $1,060 owed to the broker and have $51 leftover. Since you only invested $100, a 1% price rise resulted in a $51 gain.

If the stock price dropped 1%, the stock would be worth $1,089. You'd need to pay the $1,060 to the broker; you've also lost $11 of your original $100. Now imagine that you hold that stock for a week, and the price drops 1% every day for five trading days. You have to pay the broker $1,060, but the stock is only worth $1,046. You owe the broker $14, and you lost $100. You've taken a $114 loss. You then have to make up that loss in the future in addition to the gains you're hoping to make.

These simplified examples show you how easy it is to lose money using leverage because stock prices move up and down every day. A 1% drop in a stock's price is not unheard of. If you buy into a leveraged ETF built to amplify an index, a 1% drop could be devastating because it means many stocks dropped in price.

A leveraged ETF also resets itself every trading day to the underlying index. This means that if you were to try to buy and hold, you would have your position reduced to zero (under most ordinary volatility conditions). Over time, the mechanics of the ETF would strip away all of your funds, even if the market ended up going straight to the moon. This is a nuance lost on many new investors who try to invest in a fund meant for very short-term speculation.

Should You Invest in a Leveraged ETF?

Though the temptation to speculate with leveraged ETFs may be strong, it should be clear that they are not intended to be part of a diversified, long-term portfolio. If you have an advisor and they place one of these into your account, you should consider finding another advisor.

If you've included one in an individually managed account or bought them for your brokerage account, you are taking an extreme risk with your money.

You can and probably will lose a substantial amount of money if you keep a leveraged ETF. This is because they are designed to be traded over short time frames, like one trading day. There are leveraged ETFs designed for longer terms, such as a month, but this doesn't reduce the risk you take.

Furthermore, the payoff may not be as high as you envision. Additionally, leveraged ETFs typically have higher investment management fees of more than 1%. If you're successful trading leveraged ETFs, your gains will all be taxed at a much higher income tax rate since they are short-term gains.

If you're looking to build wealth, it is simple enough. You buy high-quality blue-chip stocks. Make sure you find stocks that let you take advantage of deferred tax liabilities through low turnover and let compounding do the rest.