Today, we dive into a unique and somewhat complicated financial product: leveraged ETFs. Full disclosure, they are on the riskier end of the investment spectrum and require active portfolio management.
Read on to see how they work and if they deserve a place in your portfolio.
🧠 What you need to know
Leveraged ETFs are financial products designed to amplify the returns of an underlying index or asset. They aim to provide a multiple (e.g., 2x or 3x) of the daily performance of the index. Generally speaking, leveraged ETFs are more complex and carry higher risk than traditional ETFs.
Anyone can invest in leveraged ETFs through their brokerage account, but it’s essential to understand their unique characteristics and risks.
Leveraged ETFs are typically more suitable for short-term trading rather than long-term investing due to daily rebalancing and compounding effects.
Types
There are over 200 leveraged ETFs traded on US exchanges. A few categories:
Bull (Long): These ETFs aim to deliver multiples of the daily performance of an underlying index or asset. For example, a 2x leveraged ETF would seek to achieve twice the daily return of the index. Examples of funds that produce 2x returns of the S&P 500 are Direxion Daily S&P 500 Bull 2× Shares (SPUU) and ProShares Ultra S&P 500 (SSO). For the Nasdaq, examples include ProShares Ultra QQQ (QLD) and Direxion Daily Nasdaq-100 Bull 3x Shares (TQQQ).
Bear (Inverse): These ETFs aim to deliver the opposite (inverse) of the daily performance of an underlying index or asset, multiplied by a specified leverage factor. For example, a -2x leveraged ETF would seek to achieve twice the inverse of the daily return of the index. Examples include ProShares UltraShort S&P 500 (SDS) and Direxion Daily S&P 500 Bear 3x Shares (SPXS). For the Nasdaq, examples are ProShares UltraShort QQQ (QID) and Direxion Daily Nasdaq-100 Bear 3x Shares (SQQQ).
Sector-Specific: These ETFs focus on specific sectors like technology, healthcare, or financials, aiming to provide leveraged exposure to a particular industry. Examples include Direxion Daily Technology Bull 3x Shares (TECL) for the technology sector and Direxion Daily Financial Bull 3x Shares (FAS) for the financial sector.
Commodity: These ETFs provide leveraged exposure to commodities such as gold, oil, or natural gas, allowing investors to amplify their gains or losses based on the performance of these assets. Examples include ProShares Ultra Gold (UGL) for gold, ProShares Ultra Bloomberg Crude Oil (UCO) for oil, and VelocityShares 3x Long Natural Gas ETN (UGAZ) for natural gas.
Key differences between leveraged and traditional ETFs
Increased exposure with less capital: Leveraged ETFs allow you to increase your market exposure without using margin. You can use them to increase market exposure and potential returns with a smaller investment.
Magnified returns and losses: Leveraged ETFs seek to multiply the daily returns of an index. This means potential for higher gains, but also higher losses.
Higher costs: Leveraged ETFs generally have higher expense ratios due to the use of derivatives and active management. These costs can impact your returns over time.
Daily rebalancing and decay: Leveraged ETFs rebalance daily to maintain their leverage ratio, so that they can accurately track a multiple of daily returns of the underlying index. This can lead to significant tracking errors over longer periods, especially in volatile markets. For example, if an index valued at 100 drops 5% to 95 one day and then gains 5% to 99.75 the next, a 2x leveraged ETF would fall to 90 (a 10% drop) and then rise to 99 (a 10% gain), not returning to the 99.75 value due to the compounding effect. Over several volatile sessions, these tracking errors can compound significantly, diverging from the expected multiple. The leveraged ETF may lose value over time even if the index returns to its initial value, experiencing decay.
🤝 How can Mezzi help?
Leveraged ETFs require careful monitoring and management to ensure returns align with expectations. Mezzi can help with:
1. Account by account tracking: If you own leveraged ETFs in multiple accounts, Mezzi makes it easy to compare performance and concentration in leveraged ETFs across accounts.
2.Fee comparison: Mezzi automatically analyzes your ETF holdings and provides suggestions for lower cost alternatives, including leveraged ETFs.
3. Taxes: You may find the need to trade leveraged ETFs more frequently. Carefully monitor tax implications and opportunities to use losses to save on taxes with Mezzi’s tax insights.
