An exchange traded fund (ETF) is a pool of stocks split into units which can be bought and sold on the exchange just like individual stocks. It is very similar to a mutual fund, the difference being that mutual funds cannot be traded on the exchange. Apart from stock ETFs, there are exchange traded funds which invest in other asset classes like commodities, currencies and so on.
The stock market allows leveraged transactions. This means that investing is done using borrowed funds. This happens mostly in derivatives trading that is, when buying and selling futures and options. When buying a futures contract of a stock, the trader / investor does not have to pay the actual cost of the entire contract but only a part of it known as margin. Though he is not actually borrowing money, it is still a leveraged trade.
A retail investor / trader does not generally indulge in leveraged derivatives trading either due to ignorance, unwillingness to take leveraged risks or due to restrictions placed by the broker. Leveraged ETFs (exchange traded funds) provide him the perfect opportunity to benefit from derivative trades.
A leveraged ETF offers the retail investor a simple way to buy a broad index or a particular sector with double or triple the exposure of the underlying index. Fund managers of leveraged ETFs strive to provide additional returns to investors by using borrowed money. The borrowed money here does not indicate any loan. Rather, it means the use of financial derivatives like options, futures and swaps.
The leverage is usually in the ratio of 2:1, in this case it is called a 2x leveraged ETF. Sometimes, the ratio is even 3:1 in this case it is referred to as a 3x leveraged ETF. A 2x leveraged ETF means that every dollar of the investor’s capital is matched with a dollar of debt by the fund management.
The returns of leveraged ETFs (exchange traded funds) are calculated on a daily basis. So if the underlying index gives a return of 1%, theoretically the leveraged ETF which tracks this index will give a 2% return. However, costs like management fees and transaction costs will prevent the investor from getting the full benefit of leveraging. It should be noted that a 1% fall in the index would result in a loss of 2%.
An exchange traded fund can take a leveraged bet in either direction of the market which means that the fund manager can go long or short. Accordingly, the ETF may be a 2x Bullish ETF or a 2x Bearish ETF. The latter is also called ‘Inverse Leveraged ETF’ which gives good returns when the market moves downward.
Leveraged ETFs are best suited for day traders who want to fully exploit even small daily market movements.
Leveraged ETFs (exchange traded funds) have to maintain their leverage ratios at all times. But daily market movements result in prices moving upward or downward altering the ratio. So the fund manager will have to keep buying and selling shares. When the market moves upward, shares would have to be sold, reducing the assets of the ETF. This is the constant leverage trap and may result in a fund doing badly.
An investor in a leveraged ETF should remember that a 10% annual appreciation of the underlying index will not give him a return of 20%. It is the daily return of the index that will determine his profits.