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Leverage can potentially enhance your investment yields, although it also brings about a greater possibility of monetary setbacks. However, assuming more risk can result in greater rewards as well. Due to their ability to make fast and short-term wagers on the stock market, leveraged ETFs are receiving substantial attention from investors and the media and are well-liked by both everyday individuals and large investment corporations.
Multiple ETFs are designed to encompass various investment categories and could potentially yield higher returns. However, leveraged ETFs are a more appropriate option for investors with extensive experience and a high tolerance for risk.
This article will explore how leveraged ETFs work and discuss some of the top-performing funds for 2024.
Key Takeaways
Leveraged ETFs aim to increase the returns of an underlying index.
These ETFs reset to that day's settlement price at the end of each trading day.
Leveraged ETFs are not suitable for long-term investments.
SOXL and TQQQ are some of the best-performing ETFs with leverage.
Explaining Leveraged ETFs
An exchange-traded fund (ETF) is a fund that tracks an index by holding a basket of securities, such as the FTSE 100. Traditional ETFs track the price of an index, such as the S&P 500, with the ETF owning the same securities as the index. On the other hand, leverage ETFs are exchange-traded funds that aim to increase the returns of an underlying index. They can track a variety of stock or bond indices, or they can be based on a single stock. Leveraged ETFs borrow money from banks or investment firms and aim to create returns that are multiples of the underlying index's return.
Common leverage ratios are double-leveraged (2x) and triple-leveraged (3x), with different options available. For instance, if a traditional ETF tracks the S&P 500 index, its 1% gain could be magnified to 2% or 3%, potentially causing losses in the market if the index loses.
Leveraged ETFs are typically used by traders to speculate on an index or take advantage of the index's short-term momentum, especially when investors believe volatility will be high. They are meant to ride the short-term trend, and risk is admissible only if the higher returns and conviction justify the kind of risk.
However, investors should consider leveraged ETFs cautiously, as losses can be higher than traditional investments. These instruments carry high expense rates due to upfront premiums on options contracts, making them one of the industry's highest expense rates. That is why proper management is crucial to avoid excessive losses and tracking errors.
What is Leverage in Leveraged ETFs?
Leveraged ETFs use options, futures, or borrowed money to boost returns by multiplying asset volatility compared to the index it tracks, but they do not aim to magnify the index's annual returns. For instance, a NASDAQ 100 ETF could convert a 1% gain in the index into a 3% gain, resulting in magnified losses.
Instead, leveraged ETFs are marked to market every night, starting with a clean slate the next day, producing daily leverage results. Over time, the compounding of this reset can potentially vary the fund's performance versus its underlying benchmark, resulting in greater or lesser degrees of final leverage over individual holding periods.
Uninformed investors often assume that leverage returns are generated continuously, but this is not the case. Leveraged funds must rebalance daily to achieve appropriate levels of assets and provide their implied leverage. For long 2-times leveraged exposure, they typically attain exposure to a notional set of assets equal to 2 times their NAV. The rebalancing activity of these funds will almost always be in the same direction as the market.
How do Leveraged ETFs Work?
At the end of each trading day, most leveraged and inverse ETFs reset to that day's settlement price, and the next day, the ETF seeks a return corresponding to its leveraged or inverse objective. If a fund is held beyond a day, the return is a compound of daily leveraged returns based on how long the investor owns the fund.
Leveraged ETFs invest borrowed money into highly speculative contract investments like futures or options to amplify the daily returns of a benchmark index by using debt or financial derivatives. These investments are risky and should be approached with caution.
The work of leveraged ETFs can be better explained using an example:
The iShares Core FTSE 100 UCITS ETF is a typical index tracker that tracks the 100 stocks in the FTSE 100. It follows a 1% movement, while a leveraged ETF uses debt to deliver 2%, 3%, or higher returns. For example, if a lithium-ion EV battery is outdated due to nickel-based battery advancements, the triple-leveraged ETF value would fall by 60%. The lithium stocks would need to rise by 150% in a non-leveraged ETF to recover from the loss. However, this allows for more significant profit if price movements are correctly predicted.
Due to amplified gains and losses, long-term positions in leveraged ETFs can be challenging to follow. The longer an investor holds the fund, the more their leveraged returns deviate from the index's nominal performance.
What Is an Inverse Leveraged ETF?
Inverse ETFs, also known as short funds, aim to achieve the inverse of the daily performance of the index they track. Inverse ETFs are considered a beneficial investment option for potentially earning profits or mitigating losses during a market downturn. Ultra-short funds, also known as leveraged inverse ETFs, aim to increase profits as the underlying index decreases.
Protecting your investments with these methods is easier than obtaining a loan from a broker. An inverse leveraged ETF is an investment vehicle that aims to deliver returns that are opposite to those of a benchmark index through the use of sophisticated financial strategies. It employs instruments such as swaps and futures contracts to accomplish its goals.
For instance, an x2 inverse leveraged ETF would double the opposite returns of its benchmark index if the benchmark fell 10%. However, the returns on inverse ETFs can differ from the underlying index, especially over longer periods.
Inverse leveraged ETF portfolios generate profits when the underlying index moves in the opposite direction or the security or index declines in value, allowing investors to profit from the bear market.
Pros and cons of leveraged ETFs
ETFs with leverage offer significant gains but also potential price declines, so investors should carefully evaluate their benefits and risks before investing. Let's discuss some of the benefits and drawbacks of this type of trading instrument.
Pros
Leveraged ETFs offer potential profits exceeding the underlying index and margin alternatives. An inverse ETF can also benefit traders when the underlying index falls in value.
ETFs with leverage offer traders a wide range of securities to choose from to trade in the open market, generating significant returns that surpass underlying indexes. They can make money during market declines and hedge against potential losses.
Leveraged ETFs offer high return potential, providing investors with indirect access to options or futures contracts without owning them. They can double or triple daily returns of benchmark indexes, and can be easily traded like a stock on an exchange.
Cons
Leveraged ETFs charge higher fees than non-leveraged ones due to upfront premiums for financial derivatives.
These instruments can cause significant losses if the underlying index value declines. Besides, they are expensive due to higher management fees, expense ratios, and operational charges.
ETFs using borrowed funds are short-term assets and might not be suitable for long-term investments. They can generate significant losses exceeding the underlying index and may take longer to recover from. Some specialised ETFs have low volume, making buying or selling shares harder, especially during against-trade trades.
Leveraged ETFs increase market risk by amplifying the returns of benchmark indexes, causing downside risk. They use financial derivatives for daily tracking but may not accurately replicate results over longer periods.
Leveraged ETF Trading Strategies
Traders and investors use leverage ETFs to speculate on an index or capitalise on short-term momentum, making these instruments best suited for day trading or swing trading. The best strategy is to hold positions in these ETFs for a few days, with day trading being the most effective as it allows for the day's return.
Due to the instrument's high-risk and high-cost structure and because a leveraged ETF resets daily, it is unsuitable for long-term investments. Leveraged ETFs face long-term challenges due to tracking errors. They must reset their holdings daily, which can cause them to fall out of sync with their benchmark index, potentially leading to excess losses.
Here are some commonly used strategies for trading leveraged ETFs.
Market Timing
Traders commonly use leveraged ETFs to time the market. They use technical analysis to identify entry and exit points, such as a bullish trend tracking the desired market index.
Pair Trading
Leveraged ETFs can be utilised in pair trading strategies. These strategies allow traders to simultaneously hold long and short positions in two correlated assets, boosting potential gains.
Volatility Trading
Traders are using leveraged ETFs to capitalise on market volatility, either by tracking volatility indexes or by employing options strategies.
Sector Rotation
Sector rotation involves traders allocating investments to different sectors based on market conditions, using leveraged ETFs to gain exposure to specific sectors and capitalise on their performance.
Best ETFs for 2024
Many leveraged and inverse-leveraged ETFs seek to follow common indices or assets. Here are some of the best-performing ETFs.
Direxion Daily Semiconductor Bull 3x Shares (SOXL)
This is one of the triple-leveraged ETFs with $5.5 billion in net assets, aiming to deliver three times the daily performance of the ICE Semiconductor Index. Semiconductors, particularly graphic processing units, are crucial for AI applications. Nvidia's surge in size in 2023 has boosted investment portfolios holding technology firms like SOXL.
The fund is suitable for high-conviction bets on semiconductor short-term moves, with a 0.94% expense ratio, but may not be ideal for long-term holds due to leverage decay.
ProShares UltraPro QQQ (TQQQ)
The ProShares UltraPro QQQ is the largest leveraged ETF, following the Nasdaq Composite's daily performance with three times the leverage. It shows $22.12 billion in assets under management and an expense ratio of 0.88%. The ETF has returned 34.89% annually over the past five years, compared to the 20.87% of the Nasdaq-100 index.
It offers exposure to 100 non-financial stocks in the index. Although not suitable for long-term investors, it has an average annual return above the Nasdaq Composite's. It offers excellent liquidity with an average daily trade volume of 111 million shares.
Volatility Shares 2X Bitcoin Strategy ETF (BITX)
The Volatility Shares 2X Bitcoin Strategy ETF (BITX) has seen a 124% increase in assets under management since its launch in June 2023, following the SEC approved leveraged ETF. This leveraged bitcoin ETF, the first to offer leveraged exposure to bitcoin, has seen its assets briefly surpass $69,000, a record high from November 2021. BITX uses CME BTC futures contracts and is designed for aggressive traders, with well-timed trades potentially leading to massive returns.
Global X Artificial Intelligence & Technology ETF (AIQ)
AIQ is an AI-leveraged ETF that provides comprehensive exposure to the entire AI value chain, focusing on technology and mid-cap growth. It tracks the Indxx Artificial Intelligence & Big Data Index and has a portfolio of 85 holdings totalling just under $2 billion in assets under management.
Top holdings include Nvidia, Netflix, Broadcom, Meta Platforms, and Qualcomm. The ETF is globally diversified, tax-efficient, and has a low 30-day SEC yield.
Bottom Line
Due to their 2x or 3x leverage strategy, leveraged ETFs offer high returns but high market risk. These investments can double or triple the benchmark index's daily returns but also create excessive market risk due to price declines. While suitable for short-term traders and advanced money managers, they provide increased returns and market exposure for new investors.
However, understanding their mechanics, risks, and considerations is crucial, as it outlines the objective and risks associated with the investment. Leveraged and inverse ETFs pose substantial risks, are typically more expensive to hold, and may be less tax-efficient due to short-term capital gains.
FAQ
How are Leveraged ETFs taxed?
They have unique tax implications compared to traditional ETFs, influenced by factors like holding period, dividends, capital gains, and investor's tax jurisdiction.
Can I hold a leveraged ETF long-term?
Leveraged ETFs are devised for short-term investment, offering increased exposure to an index's daily returns, but their performance can significantly deviate from the index's long-term returns due to the compounding effect.
Can you potentially lose more than you invest in leveraged ETFs?
Leveraged ETFs offer a risk-free investment strategy, but their rapid eroding potential can lead to significant losses, potentially exceeding the principal.
What is the most considerable risk of leveraged ETF?
Leveraged ETF volatility is a significant risk, as maintaining a constant leverage ratio can be challenging due to fluctuating underlying index prices, affecting the assets value of the funds.
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