Leveraged Exchange Traded Funds (ETFs) 101

June 25, 2009 By: M. El-Ayari Category: Investment Strategies

What Are Leveraged ETFs?

Leveraged ETFs provide 2 or 3 times the daily return of the underlying investment. Therefore, in a 2× leveraged ETF, every $1 invested yields amplified returns of a $2 or $3 investment (less fees and costs) on both the upside or downside.

Leveraged exchange-traded funds offer the following features:

1. Leverage: Leveraged ETFs provide two or three times the daily return of an underlying index.

2. Margin with Low-Maintenance: The leverage facility is managed inside the exchange-traded fund’s structure. Investors do not need to borrow outright, deal with margin calls, or roll options.

3. Inverse Exposure: By buying Bear ETFs, investors can obtain inverse returns without opening a special brokerage account. All products are exchange-traded.

4. Potentially a more cost/tax effective way to short. Typical users may range from institutional traders to individual retail investors.

Leveraged or inverse leveraged ETFs may be used for four main reasons:

1. Hedging an existing long position using the inverse ETFs.

2. Taking a speculative outright position (long or short)

3. Alpha Generation

4. Long/short and “spread” trades

Consequences of Daily Rebalancing:

Re-balancing the leveraged ETF position will improve the time period tracking error. In spite of the market’s swift adoption of leveraged Bull and Bear ETF products, aspects of their methodology have come under scrutiny in domestic press and in online investor forums. The main critique is that investors’ expected returns over time may differ significantly from their actual payoff. For example, if the underlying index gains 10% over 1 year, this doesn’t mean that the 2× Bull ETF, which is rebalanced daily, will gain 20% over the same period.

Example: Invest $100 in the 2× Bull Index product.
Returns: Day 1: +10%, Day 2: -10%.

The investment value at the end of the period is not $100, but rather: $100 × [1 + (2 x 10%)] × [1 + (2 x -10%)] = $96.00, or a 4% loss.

The rule of thumb is that in a steadily trending market with low volatility, an ETF with daily rebalancing will outperform traditional. However, if daily returns are volatile, even if the underlying index’s overall performance is positive, the 2× bullish ETF will likely underperform.

The explanation is fairly straightforward, and it has to do with the daily leverage adjustments: whenever the index experiences a large daily decline, the fund sells assets and reduces its debt level to bring the leverage ratio back to 2. This locks in losses, making it harder to recover lost
gains when the market turns higher.

Mounir R. El-Ayari, CIM, FCSI, C.h. P. Strategic Wealth
Investment Advisor
Associate Portfolio Manager
e-mail: mounir.el-ayari@nbf.ca