Dangers of Leveraged ETF's

Posted By: Advisor Analyzer Team

A relative new comer to the investment asset community is the Exchange Traded Fund or ETF for short.  ETF’s are similar to both open and closed end mutual funds in that they are a continuous offering and are traded on an exchange.  ETF’s are passively managed funds for the sole purpose of mirroring an index.  Fairly recently, ETF’s began catering to the more risk seeking investor by offering levered funds that provide exponential returns to the underlying index they track.

Traditional and Leveraged Exchange Traded Funds

Take for example, an ETF that mirrors the Dow Jones Industrial Average.  A vanilla ETF would mirror the returns of the Dow closely, and endeavor to maintain a beta ratio of 1.  A beta of 1 implies for every 1% increase in the Dow Jones, the ETF would also increase 1% and vice versa.  Therefore, one can expect to experience very similar returns, net of administration fees, to that of the underlying index.

 

However, there are many thrill seeking investors who are not satisfied with a 1 to 1 ETF ratio.  To cater to those with a heartier risk appetite, many investment companies now offer levered ETF’s, where the beta ratio is (for example) 2.  In this instance, for every 1% increase for the underlying index, the ETF would appreciate 2% and vice versa.  While this seems a very simple concept, investors should utilize levered ETF’s with strong caution.

 

Conventional ETF’s are suitable for individuals who seek to mirror the returns of an index.  There are few disadvantages to buying and holding a vanilla ETF for a long or short duration investment horizon.  However, investors should not apply the same logic when purchasing levered ETF’s since there is an exponential relationship between the fund and the underlying index. Unlike a traditional ETF where the returns are a one to one basis, performance of levered ETF’s may be unpredictable and nonlinear depending on the degree of fluctuation of the underlying index.

Simple Example of Levered ETF Risks

A simple example can demonstrate the dangers of utilizing a levered ETF.  Suppose an investor purchases a levered ETF at 100 when the underlying index is also 100.  Say the markets are experiencing significant volatility as of late, and experiences a 40% reduction in aggregate prices for the trading day.  The market now closes at a price of 60 and the levered ETF, which doubles the moves of the underlying falls 80%.  The ETF’s value is now reduced to 20. 

 

The next day, the markets completely reverse the previous day’s losses, and experiences a 100% move closing at 120.  The levered ETF, following suit, should increase by a multiple of 200%, and closes at a price of 60.  Notice the impact leverage has on the returns? 

 

An investor holding a traditional ETF would have a gain of 20 at the end of the second day, while the investor of the levered ETF is still at a loss of 40.  The magnification of price fluctuation dramatically reduces the principal basis for the investor to experience subsequent gains.  That is a major source of inherent risk for investors of levered ETF’s.

Conclusion

While they may be a useful tool to capitalize on short term trades, levered ETF’s can be a potentially dangerous asset for long term use.  When markets experience unfavorable moves with high volatility, the investor may be unable to recoup their loss for substantially longer periods than had he invested in a regular ETF.  Therefore, as with all investments, as the return potential increases, risk is sure to follow.