Leveraged Exchange Traded Funds Trading

Ever since their introduction Exchange Traded Funds (ETFs) are considered as a simple, flexible and profitable trading/investing instrument. One can now find a variety of ETFs tracking different indexes, sectors or products and having different compositions and strategies. One of the new introductions to this ETF list is the Leveraged ETFs.

Leveraged exchange traded funds tries to outperform the tracking index/market by using extra leverage. But unlike traditional leverage, trading on margin, which includes interest on margin, these funds try to use equity swaps, index options and index futures to get more leverage and to increase or decrease market exposure. Most of these funds keeps constant level of leverage, most at the ratio of 2:1 (which means double return than tracking index) and some of 3:1 (means triple return than tracking index).

Leveraged ETF firms adjust market exposure on a daily basis. So this becomes almost impossible to double or triple the return on a long-term basis. This can be explained in a simple example. If A buys a normal ETF and B buys a leveraged ETF (2:1), both tracking same index. In general if the tracking index rise 1%, A’s fund value also raises by 1% but that of B’s rise by 2%; and if the tracking index fall by 1%, A’s value falls by 1% and B’s by 2%. But in longer periods (take 5 days) things can get complex.

If first four days results in 1% drop in tacking index, the total fall in price of normal ETF will be 96.1% of original value [100 – (1+0.99+0.98+0.97)] and that of leverage one will be 92.1% [100 – 2(1+0.99+0.98+0.97)]. If the price of tracking index increases by 4.1 (which is 3.9 added to 96.1 making it 100), the price returns back to 100% for a normal ETF, but only reaches 99.65% for a leveraged ETF. This is because of the fact that the leverage ratio is adjusted on daily basis. Leveraged ETFs also have higher maintenance costs (expense ratio) than traditional ETFs because of their daily rebalancing.

Advantages of trading these instruments include 1) higher return from market, 2) better market exposure for fewer amounts, 3) managed by professionals, 4) good for short term profiting and intraday trading, 5) and all other major advantages of ETFs. Disadvantages of trading these instruments include 1) no surety of outperformance, 2) higher expense ratio, 3) not suitable for long-term trading and 5) not much performance history available.

Traders and investors are advised to carefully go through the daily leverage balancing strategy of the fund and its past daily returns in comparison to tracking index.