What Are Leveraged ETFs?
Leveraged ETFs are mutual funds that employ financial leverage strategies to maximise investment returns. For example, short selling, options trading, margin trading, etc. Leveraged ETFs aim to deliver higher returns than the benchmark or index they track. Leveraged funds use derivatives – futures, options, and swaps to generate higher returns.
Thus, leveraged exchange-traded funds have a higher risk and higher return prospects than other Exchange Traded Funds (ETF). Usually, ETFs try to replicate the index and generate more or less the same returns. On the other hand, a leveraged exchange-traded fund aims to double or triple the index’s daily returns.
A leveraged exchange-traded fund that tracks Nifty 50 might also use other financial leverage strategies to magnify the 1% gain of Nifty to a 2% or 3% gain. The amount of leverage a fund employs determines the profits.
Leveraging is an investment strategy in which borrowed funds are used to purchase options and futures in order to amplify the impact of price changes.
It is important to note that leveraged ETFs attempt to amplify the daily returns of the benchmark index and not long-term returns.
How do Leveraged ETFs Work?
A leveraged exchange-traded fund (ETF) follows the performance of a benchmark index. Furthermore, it uses debt instruments and derivatives like futures, options, swaps, reverse repurchase agreements, etc., to generate higher returns than the benchmark/ index. Leveraged ETFs, like regular ETFs, can track a sector, commodity, currency, etc.
Leveraged ETFs attempt to amplify the daily returns of a benchmark index (two or three times) rather than simply match the index’s performance. They use borrowed money to trade in derivatives (futures and options) to amplify the returns.
Thus, these ETFs take a larger position with a smaller capital. For instance, the fund buys one lot of BSE S&P 500 Futures with a 20% margin. That’s the equivalent of getting five times the leverage. This is the concept of leveraged ETFs. A leveraged Exchange Traded Fund is a fund that amplifies the returns of an underlying index by using financial derivatives and debt. These funds maintain a fixed leverage ratio during the investing period, such as 2:1 or 3:1.
It is important to note that these ETFs can sway both ways. In other words, when a fund tries to maintain a 2:1 leverage, it means the fund returns can be twice as that of the index. However, the losses can also be double.
Who Should Invest?
Traders who want to bet on an index or take advantage of the index’s short-term momentum generally invest in leveraged ETFs. Therefore, these ETFs are short term speculative investments.
Since leveraged ETFs aim to amplify daily returns, they are not suitable for the long term. Leveraged ETFs are trade-in option contracts. Options contracts have an expiration date and are short term schemes. Thus, investors who trade in leveraged ETFs have a short term investment horizon. If these ETFs are held for the long term, their returns may vary significantly from the underlying index.
Leveraged ETFs are specifically designed to ride a short-term trend. Thus you should use these ETFs only if you are confident about the trend and have a high level of conviction in it. As mentioned earlier, these ETFs can work both ways. Therefore the scheme is a high-risk scheme. Hence, only if you are comfortable with the risk level should you consider investing in leveraged ETFs.
Things to Consider as an Investor
Following are the things to consider while investing in leveraged ETFs:
Leveraged ETF funds are suitable for investors who have a short-term investment horizon. However, since they aim to magnify the returns daily, the returns may fluctuate in the long term. Thus, a short term investment tenure is necessary while dealing with these ETFs.
Understand the investment objective of the leveraged ETF before investing in it. These ETFs can track a sector, theme or broad market index. Thus, pick a suitable scheme depending on the scheme’s suitability to your investment goals.
Past performance doesn’t guarantee future returns. Furthermore, derivatives trading is highly risky. However, by analysing the fund’s historical performance, you will understand how successfully the fund manager maintained the leverage ratios.
Leveraged exchange-traded funds are high-risk investment options. These ETFs aim to amplify daily returns. Sometimes the bets can be in favour, while sometimes, they can trigger steep losses. As a result, these ETFs can lose most or all of its value. Therefore, it is vital to consider the risks involved with investing in leveraged ETFs before investing in them.
Leveraged exchange-traded funds have a higher expense ratio than normal ETFs. Since leveraged ETFs trade in financial derivatives, the expense ratio is higher. Furthermore, these ETFs are actively managed, and it requires extensive research and technical expertise. As a result, the fund manager charges a higher management fee.
Advantages of Leveraged ETFs
Following are the advantages of investing in leveraged exchange-traded funds:
- Higher Returns: These ETFs aim to magnify the daily returns, by two times or three times, of an underlying benchmark index. Thus they generate more returns than a regular ETF scheme.
- Alternative to Derivatives: Leveraged exchange-traded funds provide indirect access to financial derivatives such as options and futures contracts. Dealing in derivatives is often an expensive affair or inaccessible to common investors. Thus, through these ETFs, investors can take advantage of derivatives trading.
- Inverse Leveraged ETFs: Through Leveraged exchange-traded funds, the fund generates returns when the index declines in value. In other words, this type of ETF benefits during a market downturn as it takes short positions.
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