Upon answering the question ''How do leveraged ETFs work?'' it is also necessary to highlight the various advantages they provide to investors. The various advantages of leveraged ETFs are:
- Leveraged ETFs trade their shares in the open market like stocks.
- Leveraged ETFs amplify daily investor earnings and enable traders to generate returns and hedge them from potential losses.
- Leveraged ETFs mirror the returns of investors of an index with few tracking errors.
Compounding refers to the ability of a security to generate earnings that are reinvested to generate their income. Precisely, it is when assets can generate profits from previous ones. Compounding can translate to losses in ETFs when markets are volatile based on the underlying conditions.
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Leveraged ETFs are beneficial when an investor makes a correct prediction in the market. Any move in the market could generate significant returns when predictions are correct. However, if predictions are incorrect, the investor may incur tremendous losses, making the ETFs risky as well. Examples of leveraged ETF risks include leveraged ETF decay, volatility, and risky high-beta leveraged ETF. Leveraged ETF decay describes the low performance emanating from the multiplying effect on the underlying index of the leveraged ETFs. Volatility refers to where a stock price fluctuates rapidly over a short timeframe. The risky high-beta describes the adverse effects of changes in derivatives' prices when there is a change in the underlying security. They are more volatile than the market.
Decay of Leveraged ETF
An example of leveraged ETF risk is the leveraged ETF decay. Leveraged ETFs are meant to be bought and held for short periods. When held for extended periods, they depict decay even when price movements in the market are convenient. They are also unsuitable for long-term trading because of the high fees, where the expense ratios are usually higher than 1%. Leveraged ETFs rebalance daily, and as the amplification of the daily returns of an index continues, it does not portray an equal multiple as that of annual returns. As the leverage multiple heightens, the volatility decay worsens. Therefore, as the stock volatility heightens, the leverage ETF decay also depicts an uptrend causing underperformance.
Volatility of Leveraged ETF
Another leveraged ETF risk is the leveraged ETF volatility. Maintaining a constant leverage ratio that is probably two or three times the usual amount is typically hard. The price of the underlying index fluctuates, changing the leveraged funds' assets value, depicting high volatility. Volatility is a measure of the degree of change in an investment's price over a given period. A highly volatile stock is deemed to depict regular and quick price changes. In contrast, a less volatile stock has minimal changes in its price over time. When volatility heightens, the compound risk also rises, causing underperformance in the stock. Eventually, the investor may incur steep losses because the compound returns decline with the rise in volatility.
Risky High-Beta Leveraged ETF
The high-beta is another leveraged ETF risk in the market. Beta is the term used to compare the volatility levels of stocks in the market. Therefore, a high-beta means that a stock has high volatility. The general market beta is 1.0, so if the stock beta is at 1.0, it means it is the same as that of the market. High-beta is deemed more volatile and hence riskier, while low-beta is less risky as it is less volatile. Therefore, high-beta stocks have a beta of more than 1.0, meaning that they have higher volatility than the market, which holds a beta of 1.0. The risk in high-beta stocks may be balanced by a spread-out investment period, which is unfavorable for leveraged ETFs, which require short-term investment periods.
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Leveraged ETF long-term trading is deemed inappropriate because leveraged ETFs are meant to amplify index returns of short-term investors, especially day traders. In regular ETFs, the net asset value sometimes deviates from the market price, but the performance eventually tracks the underlying index and balances it in the long run. This is unlike the leveraged ETFs, which use debt and financial derivatives to generate high gains from the risks involved. Therefore, leveraged ETFs are preferable to day traders because the risk can be hedged in a day due to the volatility. However, long-term investors may suffer massive losses. If the volatility goes too high, the portfolio value may decrease to zero because of compounding.
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The fundamental assets of leveraged exchange-traded funds are futures contracts based on the index that the fund tracks. Leveraged ETFs are affected by volatility in the sense that increasing volatility results in increased decay. High-beta equities are those that, in comparison to the market as a whole, have a greater propensity to experience price fluctuations. High-beta means that the asset has high volatility, which may cause it to portray underperformance. Therefore, the investor may eventually incur steep losses. The individual companies that comprise the underlying index are what is known as the typical underlying holdings of a regular exchange-traded fund (ETF). Leveraged exchange-traded funds are comparable to standard exchange-traded funds since their trading activity is analogous to equities on an index. Leveraged ETFs are beneficial because they amplify investors' daily earnings and hedge them from potential losses. They also mirror the investor returns of an index with minimal tracking errors. Leveraged ETFs are preferable to day traders because they amplify investors' returns over a short period and not in the long run.
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Video Transcript
The Double-Edged Sword of Leverage
Among the most controversial new products in the investment landscape are leveraged ETFs. Meant to be short-term trading vehicles, these are one of the most misunderstood products available. In this lesson, we'll explore what leveraged ETFs are along with some of the risks and opportunities made available through their use.
Exchange-Traded Funds
Traditional ETFs, or exchange-traded funds, are a basket of stocks sold as a unit which try to emulate an underlying market index. The most popular ETFs are constructed to mirror the performance of major market indexes like the S&P 500 or the NASDAQ 100. The underlying holdings in the ETF are put together so that the ETF moves in the same direction and by nearly the same amount as the index the ETF is trying to emulate.
The underlying holdings of an ETF are the individual securities that make up the ETF. Rather than going out and buying all the individual stocks which make up the ETF, an investor can purchase the ETF on an exchange just like a stock. They would own a basket of stocks just by making a single transaction.
For example, the NASDAQ 100 ETF would be a basket of the 100 stocks which make up the NASDAQ 100 Index. Since the holdings in the ETF are identical to the index the ETF is tracking, the daily performance of the ETF should mirror the index it's following. So, the NASDAQ 100 ETF should have about the same daily performance of the NASDAQ 100 Index. The underlying index is the index an ETF is tracking the performance of or mirroring. Here, the underlying index would be the NASDAQ 100.
Leveraged ETFs take this one step further. Rather than have a basket of stocks that attempt to mirror the performance of an index, leveraged ETFs use derivatives in order to multiply the daily return of the underlying index they're tracking. Leveraged ETFs will buy futures contracts to gain two-times or three-times the daily move of the underlying index. It is this use of derivatives which adds risks to leveraged ETFs that are not present in more traditional ETFs (which just hold individual stocks). Just like traditional ETFs, leveraged ETFs can be bought and sold on the stock exchange each day. You can trade leveraged ETFs like traditional ETFs or any stock.
Decay, Risk, and Volatility
One major factor seen in leveraged ETFs is decay. This decay is a function of the math behind having a multiplier. Let's use the example of two ETFs. The first, ABC, is an ETF that tracks the Big Index. The second, XYZ, is a leveraged ETF that returns two times the Big Index. Both the ABC and XYZ ETFs start off trading at $10 per share. Day 1, the Big Index is up 25%. The next day, the Big Index drops 20%.
After the first day, ABC rallies from $10 to $12.50, up 25% in-step with the Big Index, while XYZ goes from $10 to $15. The second day, ABC shares give back 20% or $2.50 to close back at $10. XYZ, on the other hand, gives up twice the 20% of the Big Index, 40% or $6 to close the day at $9. Even though the Big Index and ABC ETFs are both breakeven from where they started, the leveraged ETF XYZ is down $1, trading below where it started two days before. In terms of leveraged ETFs, decay is the loss of performance attributed to the multiplying effect on returns of the underlying index of the leveraged ETFs. In the example, the decay took $1 or 10% off the performance of the leveraged ETF.
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This decay is compounded with the volatility of returns. Volatility is the variance of returns. Put another way, the more up and down a stock is the greater the volatility of that stock. With leveraged ETFs, since decay can eat away at profits, volatility is a huge negative factor on leveraged ETF returns. The good news is, as long as the underlying index moves in a singular direction, the effect of decay is minimal. Once there are negative days thrown in the mix, decay rears its ugly head as in the example.
Since leveraged ETFs move as a multiple of the underlying index, there is additional risk you don't see with the underlying index. While larger indexes like the S&P 500 typically move in a smaller range than individual stocks do, smaller indexes can have wild swings. There are leveraged ETFs which track high-beta sectors of the market. High-beta stocks are more volatile than the broad market. Leveraged ETFs which track these high-beta sectors can swing 20% or more in either direction on any given day.
This leverage can cut both ways. While leverage is fantastic when a trade is moving in your desired direction, it can be devastating when it works against you.
Lesson Summary
All right, let's briefly review the key concepts we covered in this lesson, starting with the concepts we covered regarding exchange-traded funds, we learned that:
- Exchange-traded funds (ETFs) are a basket of stocks sold as a unit which try to emulate an underlying market index.
- Leveraged ETFs use derivatives in order to multiply the daily return of the underlying index they are tracking.
- Underlying holdings of an ETF are the individual securities that make up an ETF.
- And finally, the underlying index is the index an ETF is tracking the performance of or mirroring.
Then we learned about decay, volatility, and high-beta stocks, as well as the risks involved.
- Decay is the loss of performance attributed to the multiplying effect on returns of the underlying index of the leveraged ETFs.
- Volatility is the variance of returns.
- And finally, high-beta stocks are more volatile than the broad market.
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