Exchange Traded Funds (ETFs) have exploded in popularity over the past decade. These investment funds hold a collection of assets (cash, stocks, bonds, commodities, etc) and are commonly designed to track the performance of a certain index or sector. Unlike their predecessor in retail investing (mutual funds), ETFs can be bought and sold on a stock exchange throughout the trading day, similar to individual stocks. This makes them highly liquid and offers investors added flexibility in trading. Their structure also provides for some tax benefits and typically lower expense ratios as compared to mutual funds.

For all these reasons, ETFs have become very popular with investors and when investment products become popular, you can be certain that firms selling and marketing those products pay attention – and come up with more and more products to sell investors. As a result, the ETF space has become increasingly diversified and complex, resulting in a need for investors to carefully research these investments and fully understand what it is they are investing in.

One particular slice of the ETF pie that deserves careful attention and diligence is the leveraged ETF world. A client asked about these this week so let’s take a closer look

What is a Leveraged ETF?

The term leverage in the finance world refers to using debt to magnify investment returns. In simple terms, you borrow money so you can turn around and invest more than you have on hand in cash. This is the basic premise of leveraged ETFs. In the ETF world, while a standard ETF seeks to replicate the return of an index, levered ETFs seek to provide a multiplied level of that return (usually 2x but sometimes 3x).

Leveraged ETFs don’t actually hold the assets. Instead, they use financial instruments like futures contracts, options, and swaps to amplify the daily returns. The funds must rebalance their portfolios daily to maintain their desired leverage ratio (ie: 2 to 1, 3 to 1).

Leveraged ETFs can mirror the return of an index but there are also leveraged ETFs designed to mirror the return of a single stock. The ETFs can allow you to participate in the upside (go long the position/index) and there are others that allow you to bet on the downside (go short the position/index).

Performance Reality Check

This post from Fidelity illustrates the complexity of these investments – and the challenge in using these for long-term investing strategies. You may think that a levered ETF will simply return what it’s name says – ie: a 2x S&P 500 ETF will return you twice what the S&P index earns in any given timeframe. That is not how these work. See article for an example but this divergence is due to the fact ETFs have to rebalance each night, resetting their leverage to the promised level each and every day. This mechanical exercise tends to result in the returns of these ETFs to lag the benchmark position in rising markets and to underperform the benchmark position in falling market (on long positions)

Buyer Beware

Sure, if you catch a market movement in the right direction, you stand to generate nice returns on your investment that are magnified by the leverage. However, if you are wrong, the move the other direction can be very detrimental. Further, these leveraged ETFs tend to be rather costly (expenses are deducted from daily price so you don’t “see” the costs) due to the expenses associated with leverage and derivatives used to accomplish their ETF’s objectives.

Windermere does not invest in these instruments for clients due to the complexities and risks outlined above outweighing the perceived benefits. But of course, you are in charge of your own financial decisions. If you choose to pursue these financial instruments on your own, please do so with extreme caution and make sure you fully understand the deal you are making before you place the trade.