A leveraged exchange-traded fund (ETF) is a marketable security where financial derivatives and debt is utilized to amplify the potential returns of an underlying index.

If you are used to standard ETFs you know that they typically track its underlying security on a one-to-one basis. A leveraged ETF can instead go for a ratio that is two-for-one, three-for-one or even higher.

The leverage can boost earnings, but will also boost losses. It should also be noted that leveraged ETFs are used for short-term speculation and large profits or large losses can be incurred very quickly.

Standard EFT vs. Leveraged EFT

Example:

• This is a standard ETF and it tracks the S&P 500 Index. It contains the 500 stocks that make up the S&P 500. In most situations, this ETF will move 1% if the S&P 500 moves 1%.
• This is a leveraged ETF and it tracks the S&P Index. It aims to turn each 1% move of the S&P 500 into a 2% move for the fund. To achieve this, it utilizes financial products and debt (leveraging). Typically, borrowed money is used to buy options and futures to boost the impact of the index movements. It is great for the investor when the S&P 500 moves 1% up and the fund moves 2% up, but less fun when the index moves 1% down and the fund drops 2% down. Both increases and decreases are magnified for a leveraged EFT.

What indices are availble?

Leveraged ETFs are available for a wide range of indices. Some of the most popular ones are the Nasdaq 100 Index, the Dow Jones Industrial Average (DIJA) and the S&P 500 Index. 

Beware of fees and other costs

It is important to check out management fees and other costs before you invest in any fund, but it is especially important for leveraged ETFs since some of them charge very high fees and/or are associated with some serious transaction costs. Fees and costs can easily diminsh a trader´s profits from a leveraged ETF and even turn a profit into a loss.

Please note that for the fund, using leverage is not free –  it is paying for it. This is a cost that a standard ETF does not have. When the fund uses leverage, it is borrowing money from the broker.

It is not unusual for leveraged ETFs to have expense ratios of 1% or even more. Two important costs are the premiums paid for options contracts and the interest rates paid for borrowing money.

How can the magnification be achieved?

At first glance, it looks almost like magic. How can a fund based on the S&P 500 increase by 3% each time the S&P 500 index go up by 1%?

The truth is that instead of magic, the fund utilizes a combination of leverage and financial derivatives to achieve the boost.

One example of a commonly utilized derivative is the options contract. An options contract (which gives the owner the right to trade an underlying asset within a certain time frame) will have an upfront fee known as a premium, which is a cost for the fund. 

What is a leveraged inverse ETF?

A leveraged inverse ETF is constructed with the aim of going in the opposite direction of the underlying index. So, if the index goes down, the fund goes up. If the index goes up, the fund goes down.

The leveraged inverse ETF is a popular choice among traders who wish to benefit from bearish market conditions.

Using leverage is not free – but neither are other forms of margin trading

As mentioned above, the leveraged exchange-traded fund will have expenses, and one of these  expenses is the price paid for using leverage. With that said, it should be noted that using leveraged ETFs can actually be cheaper for the investor than using other forms of leverage and credits. Always compare the pros and cons before you make any financial decisions.

It is also important to remember that if you are using margin when trading in your own name (instead of simply buying leveraged ETF:s), you are borrowing the money from the broker and you are responsible for handling any margin call. A margin call occurs when the broker demands that you put more money into your account, because the position you opened is no longer valuable enough to be sufficient collateral for the loan.

Pros & Cons

Good for short-term but not for long-term

Leveraged ETFs are typically used by traders who wish to capitalize on the short-term momentum of an index. They are not recommended as longer-term investments, due to their high-risk nature and high-cost structure. It is even quite complicated to hold long-term investments in leveraged ETFs since the typical derivatives used to create these funds are short-term derivatives, e.g. options that will expire very soon.

Traders normally hold positions in leveraged ETFs for a maximum of a few days, and for many traders even a few days would be way too long for their leveraged ETF strategy. 

Everything is boosted – the good and the bad

Leveraged ETFs are created with the aim of boosting index movements. This is true for both directions; they will boost decreases as well as increases.

Pro: You can make money even when indices are dropping

Inverse leveraged ETFs can be used to profit from falling indices (indexes). 

Con: The costs