Everything Traders Need To Know About Leveraged ETFs

The idea of a leveraged ETF is fairly simple and appealing. If a trader is bullish on the S&P 500, why settle for investing in the SPDR S&P 500 ETF Trust (NYSE: SPY) when the Direxion Daily S&P 500 Bull 3X Shares(ETF) (NYSE: SPXL), or another leveraged ETF like it, could triple its gains?

But before you go and invest in a leveraged ETF to potentially triple your gains, it’s important to understand how they actually work.

WHAT IS A LEVERAGED ETF?

ETFs are funds that own a number of different investments, usually with the objective of meeting a particular goal. While many ETFs will simply try to mirror the performance of an index, leveraged ETFs take this mirroring to the next level.

Levered ETFs aim to generate two or three times the return of the underlying index, commodity or other benchmark. For example, when the S&P 500 delivers a 1 percent daily gain, the SPXL should theoretically gain 3 percent. On the other side of the trade, the Direxion Daily S&P 500 Bear 3X Shares (NYSE: SPXS) will seek to deliver a 3 percent loss for every 1 percent loss in the S&P 500 index.

HOW DO LEVERAGED ETFS WORK?

Just like non-leveraged ETFs, leveraged ETFs are made up of a basket of individual securities. However leveraged ETFs have added exposure built into the fund, usually in the form of futures contracts or credit swaps, to increase potential returns.

Because of this added leverage, the impact on the fund’s daily rebalancing can be significant, which can cause a leveraged ETFs performance to deviate from its stated goal day-to-day.

The chart below shows the top three derivative investments held by each of the major leveraged S&P 50 index ETFs as of earlier this year.

THE RISKS OF OWNING LEVERAGED ETFS

Perhaps at this point, the risks of owning these leveraged ETFs are becoming clear. But first, it’s important to understand that there’s nothing inherently dubious about these funds. On any given day, leveraged ETFs do exactly what they’re designed to, and investors experience the jubilation or disappointment associated with earning three times the return of the S&P 500.

However, the first risk involved with leveraged ETFs tends to play out if investors buy and hold the fund for longer than a single day. By design, these funds reset every day. The fees associated with the constant churn of buying and selling daily contracts is passed on to investors. In addition, the time value loss associated with options and other contracts also weighs on returns.

Furthermore, the assets the funds own don’t always perform as expected relative to their benchmark indices. Sometimes this tracking error works in investors’ favor. For example, in the past year the SPXL has gained 53.1 percent, while the S&P 500 has delivered only a 15.2 percent gain. At other times, however, tracking error leads to underperformance as well.

Finally, on the off chance that the U.S. financial system suffers another systemic financial crisis, the derivatives that leveraged ETFs own are exposed to counterparty risk. That risk means the value of these derivative contracts is only as good as the credit of the handful of banks which hold them.

The most important thing to remember when looking at a leveraged ETF is…

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