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What is a leveraged ETF?

ETFs Make Using Leverage Easy

Historically, to buy stocks using leverage, you had to have a margin account with your broker. Trading on margin is pretty much the same as borrowing money from your broker on a line of credit. There are limits on how much you can borrow, and you pay interest on the amount you have borrowed from you broker. Another limitation is that IRA accounts are not allowed to buy stocks on margin.

ETFs offer a dramatically different way to invest with leverage, as you can easily buy a leveraged ETF, and there are leveraged ETFs that track all kinds of markets. Leveraged ETFs are ETFs that track an index, but with some complicated trading techniques using derivatives the leveraged ETFs try to go up or down every day in an amount twice or three times the amount that the actual index goes up or down. If the index they are tracking goes up 1% on a given day, a leveraged 2x ETF tracking the same index will go up 2%. Or if the index goes down 1% on a given day, the leveraged 2x ETF tracking the same index will go down 2%.

As an example, let's look at SSO, a 2x ETF that tracks the S&P 500:

SSO has an expense ratio of 0.009000 and an average trading volume of 7,466,952 shares. In today's low interest environment, margin interest rates are typically 2% to 7%, depending on your broker and how much you are borrowing. So using a leveraged ETF like SSO is theoretically a cheaper way to leverage your investment portfolio.

As of today, there are 211 leveraged ETFs. To give you some feel for how popular they are, the total average daily trading volume of these leveraged ETFs is 1,003,137,968 shares.

Asset Allocation1
Global Equity 51
Special Security Types5
US Equity113
US Fixed Income 13

If interested, you can browse the complete list of leveraged ETFs. Just seeing the list may give you more insight into the breadth of leveraged ETFs available on the market today.

Leveraged ETFs apply different amounts of leverage:

Leverage factorNumber of ETFs

How do they do it?

A leveraged ETF typically achieves the leverage by buying and selling derivative products, including futures contracts and swap agreements, to obtain the desired exposure to the index. These derivatives are agreements that provide the ability to gain exposure to respective indexes and sectors without the need for full dollar-for-dollar investment. The swap agreements are typically private agreements that the leveraged ETF has with the major international investment banks like UBS, Credit Suisse, Morgan Stanley and Goldman Sachs. Some ETF sponsors actually disclose on their website who the swap agreements are with, while other ETF sponsors do not (those ETF sponsors merely list "S&P 500 index swap" as a holding, without mentioning the investment bank that it is with).

In addition to the derivatives, most leveraged long ETFs actually own individual securities related to the index they track, or the leveraged ETF will own shares in a non-leveraged ETF that tracks the same index. For example, TNA, the Direxion Daily Small Cap Bull 3x Shares ETF, usually owns shares of IWM, the iShares Russell 2000 ETF, a non-leveraged ETF that tracks the same index as TNA. Leveraged inverse ETFs typically just own derivatives.

Leveraged ETFs typically also have quite a bit of cash and short-term securities on hand. This is partly because they don't need all of their available cash to purchase the required derivatives, and because they typically are required to have excess cash on hand in order to meet reserve requirements imposed by the swap agreements.

With many long leveraged ETFs, it is sometimes difficult to figure out why they own the securities they own, versus the amount of cash and short-term securities they have on hand. TNA, for example, has a market capitalization in excess of $700 million, but typically only owns a small percentage of that in IWM. Running a leveraged ETF requires a complex set of calculations every day to make sure that the ETF has the proper leveraged exposure to the index, which causes the ETF to have a difficult to understand mix of cash, securities and derivatives.

Leveraged ETFs Have A Hard Time Tracking Their Index

Even though leveraged ETFs are fairly good at managing to get their results to match the results of the index on any given day, they can't and don't track the results of the index over longer periods of time. If you read their disclosures carefully, leveraged ETFs admit that they can't track the results of an index over longer periods of time - their only goal is to track the results of the index on a daily basis.

Most leveraged ETFs rebalance or reset their leverage on a daily basis. What does that mean? Every day, the leveraged ETF has to adjust their balance sheet -- the complex mix of derivatives, securities and cash on hand -- to ensure that they have 2x or 3x exposure to their index. This isn't easy. For example, let's assume that on day one a leveraged 3x ETF has a $100,000,000 exposure to the S&P 500 Index. If the next day, the S&P 500 index goes up 1.2%, the leveraged 3x ETF has to figure out which combination of cash, securities and derivatives have to be purchased or sold so that by tomorrow the leveraged 3x ETF continues to have the right 3x exposure to the index.

It's important to understand the effect of daily compounding of a leveraged ETF. The mathematics of why the "daily compounding" and "daily re-setting" of a leveraged ETF distorts the performance of a leveraged ETF over time can get complicated. But the effect of this daily compounding can be significant. FINRA notice 09-31 states:

Most leveraged and inverse ETFs 'reset' daily, meaning that they are designed to achieve their stated objectives on a daily basis. Due to the effect of compounding, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time."

It is hard to explain the impact of daily compounding on a leveraged ETF without just running through some math examples.

Example 1 - volatile market

Imagine a very volatile asset that goes up 5% one day and down 4% the day after. A perfect double leveraged ETF that tracks the same asset goes up 10% the first day and down 8% the second day. On the close of the second day, the underlying asset has gained .8%:

(1 + 0.05) x (1 - 0.04) = 1.008

The perfect 2x leveraged ETF has gained 1.2%, not 1.6%:

(1 + 0.1) x (1 - 0.08) = 1.012

This is normal behavior due to rebalancing the fund's holdings every day to reach the daily target.

Example 2 - strongly trended market

Imagine an asset going up 10% two days in a row. On the second day, the asset has gone up 21%:

(1 + 0.1) * (1 + 0.1) = 1.21

The perfect 2x leveraged ETF is up 44%, more than twice 21%:

(1 + 0.2) * (1 + 0.2) = 1.44

You can imagine that these impacts are even greater with a leveraged 3x ETF!

Summarized Impacts

Now that you understand the math, here is a summary of the effect of daily compounding on a leveraged ETF's results over time:

Here's some examples:

From December 24, 2012 to March 28, 2013, the ETF SPY (which tracks the S&P 500 Index) went up 9.7% but the leveraged 3x ETF UPRO (which also tracks the S&P 500 Index) went up 31.5%.

From December 24, 2012 to March 28, 2013, the ETF EEM (which tracks the MSCI Emerging Markets Stock Index) went down 1.1% but the leveraged 3x ETF EDC (which also tracks the MSCI Emerging Markets Stock Index) went down 5.5%.

Another way to visually see this effect is to look at a chart of one of our ratio symbols UPRO:SPY, which is simply the ratio of UPRO's market price to SPY's market price:

As you can see, UPRO:SPY goes up during strong bull periods such as were experienced during 2013 and 2014 - i.e. when SPY is in a strong upward trend, UPRO does even better, because of the daily compounding. But during October and November of 2012, when SPY was in a down turn, UPRO:SPY also went down, meaning that UPRO did worse than 3x times SPY.

UPRO is a 3x leveraged ETF. A 2x leveraged ETF that resets daily has the same challenge, but it's not quite as dramatic. For example, let's look at SSO, a 2x ETF that tracks the S&P 500:

Here's the ratio of SSO to SPY:

The same pattern can be seen. In a strong bull market, SSO can do even better than 2x the results of SPY. In a strong downturn, SSO can do even worse than 2x the results of SPY. So beware!

Why Do Leveraged ETFs Have Dividends?

A leveraged ETF does NOT pay dividends based on the dividends of the underlying index it is trying to track (there is a special class of leveraged ETNs that do pay dividends based on the underlying dividends - see read more about leveraged high dividend ETNs). But many leveraged ETFs, including leveraged inverse ETFs, nevertheless pay dividends. And often the dividends can be significant, although they are usually hard to predict and vary substantially from period to period.

A leveraged ETF can have dividends for two reasons. As explained above, leveraged ETFs use derivatives to provide the fund with the desired exposure to an index or benchmark, without consuming all of the ETF's cash. As a result, the leveraged ETF has cash available to invest in debt securities and/or money market instruments which generally earn prevailing interest rates. This short-term net investment income has to be distributed to shareholders. Alternatively, during the course of buying and selling futures contracts and/or swap agreements, the fund may generate short-term capital gains, which also have to be distributed to shareholders. All Investment Company Act of 1940 ETFs are required by IRS regulations to distribute substantially all of their net investment income and capital gains to shareholders at least annually.

All data is a live query from our database. The wording was last updated: 12/21/2017.

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