what is a leveraged etf 
a leveraged exchange traded fund letf is a security that uses financial derivatives and debt to amplify the returns of an underlying index or other assets it tracks some leveraged or geared etfs track specific stocks which were introduced in 2022 and crypto which can make an already volatile trading strategy far more combustible 12 while a traditional etf typically tracks the securities in its underlying index on a one to one basis an letf will aim for a 2 1 or 3 1 ratio these products are available for most indexes such as the nasdaq 100 index and the dow jones industrial average 3investopedia michela buttignolbut first a word of caution is in order the securities and exchange commission sec first allowed letfs in 2006 4 ever since market analysts have been concerned about their effect on overall market volatility since they can magnify major swings in the market 1 but they also as we do here never fail to warn investors to avoid them as long term investments 3 they are meant for day to day trading and their results over longer periods are unpredictable and can significantly compound losses 5 for these reasons they come under perennial regulatory scrutiny before investing in one read the prospectus and understand the mechanics of these complicated trading instruments leveraged etfs explainedetfs sell like other securities on the stock market and contain a basket of securities these securities could be from an index they track a hand picked theme of stocks or individual stocks derivatives fixed income securities and currency for example etfs that track the s p 500 index contain the 500 stocks in the s p 500 typically if the s p moves 1 the etf will also move by 1 6an letf that tracks the s p 500 would use financial products and debt that magnify each 1 gain in the s p to a 2 or 3 gain the extent of the gain depends on the amount of leverage used leveraging is an investing strategy that uses borrowed funds to buy futures and other derivatives to increase the impact of changes in price letfs primarily use futures contracts index futures and swap agreements to magnify the daily returns of the underlying index stock or other tracked assets 7 these derivatives are needed for the daily rebalancing these letfs require more on this crucial aspect below this leverage can work in the opposite direction and lead to losses for magnified losses if the underlying index falls by 1 the loss is exaggerated by the leverage investors should be aware of the risks of letfs since the risk of losses is far higher than those from traditional investments as d j abner notes in his etf handbook while investors notoriously fail to read prospectuses and investor warnings before putting money into securities this is decidedly not the time to do so 3lastly the management fees and transaction costs associated with letfs can diminish the fund s return 8 for the 170 letfs it tracks in the u s markets etf com puts the average expense ratio at 1 02 9the leverage in leveraged etfsan letf applies derivatives to magnify the exposure to a particular index or other targeted asset stocks cryptocurrency commodities etc 10 it does not aim to amplify the monthly or annual returns of the target assets but instead tracks daily changes resetting each day 8the leverage in letfs comes from several sources first it can come from borrowing for instance the fund that aims to have twice the return of the targeted assets might take your invested funds and then borrow the same amount to effectively double how much is invested 11 letfs also employ derivatives like forward contracts futures contracts total return swaps and less frequently options 7futures contracts agreements to buy or sell an asset at a predetermined price at a specific time they are traded on exchanges and the parties have to fulfill the contract at its maturity date forward contracts like futures forwards are contracts to trade an asset at a set price in the future however unlike futures they are not standardized but are customizable private agreements total return swaps where one party agrees to pay the total return including dividends interest and capital gains of a tracked asset or set of assets to another party that pays a fixed or floating rate it s a way to gain exposure to an asset s return without owning it options options contracts grant an investor the ability to buy a call option or sell a put option an underlying asset without the obligation to buy or sell the security options contracts have an expiration date for when any action must be completed they are fundamentally different from futures and forwards which put obligations on both parties and from swaps which involve exchanging cash flows or returns employing derivatives for generating returns is a method known as synthetic replication the flip side of physical replication directly borrowing which is generally more efficient than borrowing to buy the securities of the benchmark 3 regarding options they have upfront fees called premiums that allow investors to buy many shares of a security 12 as a result options layered with investments such as stocks can add to the gains for letfs over 1 1 traditional etfs a leveraged inverse etf uses its leverage to make money when the underlying index is declining in value 13 in other words an inverse etf rises while the underlying index is falling allowing investors to profit from a bearish market or market declines 8the costs of leveragealong with management and transaction fee expenses there are other costs associated with letfs 5 these funds have higher fees than non leveraged etfs because premiums fees and interest need to be paid on the derivatives and for margin costs 8 many letfs have expense ratios of 1 or more 9despite the higher expense ratios associated with letfs they are often less expensive than other forms of margin trading on margin involves a broker lending money to a customer so that the borrower can buy securities with the securities held as collateral for the loan the broker also charges an interest rate for the margin loan for example short selling which involves borrowing shares from a broker to bet on a downward move can carry fees of 3 or more on the amount borrowed the use of margin to buy stock can become similarly expensive and can result in margin calls should the position begin losing money a margin call happens when a broker asks for more money to shore up the account if the collateral securities are losing value an fall below a certain minimum 14leveraged etfs are short term instrumentsletfs are typically used by day traders speculating on an index or other targeted sets of assets it is difficult to hold long term investments in letfs because the derivatives used for the leverage are not long term investments as a result traders often hold positions in letfs for day trading 8these etfs should not be used for long term strategies since they re anchored in techniques for returns within a trading day not a longer time and the daily reset means the fund can t build on itself 10 if you want etfs for long term investing there are myriad financial products for that 1letfs offer the potential for significant gains that exceed the tracked index or assets investors have a wide variety of securities to trade using letfs investors can make money when the market is declining using inverse letfs letfs can lead to significant losses that exceed the tracked index or assets letfs have higher fees and expense ratios compared with traditional etfs letfs are not long term investments real world example of a leveraged etfthe direxion daily financial bull 3x shares fas etf holds equities in large u s financial companies by tracking the financial select sector index it has an expense ratio of 0 96 and it tracks securities that include berkshire hathaway brk b visa v jpmorgan chase co jpm and other financial companies in the s p 500 this letf aims to provide investors three times 3x the return on the moves in the financial stocks it tracks 15 to do this the fund invests in swap agreements index securities and etfs that track the index now suppose an investor bought 10 000 of fas and the underlying financial stocks rose by 1 in a single day fas would seek to provide 3 returns on that day this means the 10 000 investment would increase to 10 300 at the end of the day before fees however because letfs reset each day the gains are not compounded over days tomorrow is another day entirely conversely if the tracked financial stocks declined 2 in a day fas would aim for a 6 decline for that same day so the original 10 000 investment would decrease to 9 400 before accounting for fees as this example shows the multiplier works both ways you can get three times the gains during a positive performance and three times the losses when the index declines the impact of daily resetsthe daily reset mechanism causes letfs to rebalance their entire portfolios daily to maintain their leverage thus they won t work necessarily for a buy and hold strategy since they don t allow gains and losses to compound over longer periods this resetting effect allows the etf to seek 3x leverage daily but can cause longer term returns to diverge significantly from simply multiplying the underlying index s total returns by 3x to demonstrate this here is an example covering several days let s assume the underlying financial index fas tracks has the following daily returns we need to triple each of these for the expected return of fas 3 0 6 0 and 1 5 respectively for the three days above on day 1 since the index rose 1 fas would seek to provide 3x that return or 3 0 so the 10 000 investment would rise to 10 300 but on day 2 the index fell 2 0 so fas would target returns of 3 x 2 6 the 10 300 balance would decline by 6 to 9 682 on day 3 the index rose 0 5 so fas would attempt to return 3 x 0 5 1 5 so the balance moves from 9 682 to 9 827 a net loss of 1 73 as you can see the daily reset prevents the gains and losses from compounding over several days the leveraged position is reset completely rather than just adding 3x each day s additional gain or loss while the index declined 0 5 over the three days the 3x letf declined more than 1 7 over the same period because of the effects of daily rebalancing which is more than 1 5 loss expected by multiplying the index return by three thus letf returns can significantly diverge from a simple multiplier of the underlying index s returns in volatile conditions over those same periods the sequence of daily gains and losses matters because of the daily reset mechanism so while useful for short term trading strategies letfs like fas generally should not be expected to achieve a consistent 3x return compared with the tracked index or assets for longer periods 