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Leveraged ETFs – should investors avoid them?

We take a look at the basics behind leveraged ETFs, how they work and the risks involved.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

The popularity of leveraged exchange traded funds, better known as ETFs, has ballooned over the past year. The amount of investors’ money being heaped into these higher risk investments has almost doubled.

The rise to fame has mostly been fuelled by the pandemic. With ample time and cash savings at our disposal, lockdowns have injected a fresh dose of investors into the stock market.

Leverage is very much a double-edged sword. On one hand, the value of your investments can climb rapidly if the market moves in your favour. On the other hand, any gains and your original investment can be cleaned out should things take a turn for the worse.

It’s important to stress that investing in leveraged investments is complex and a high-risk strategy. They’re designed for short-term day trading (less than one day). We believe in investing for the long term (that’s at least five years) and encourage investors to do the same.

In this article, we look at the basics behind leveraged investments to help investors understand how they work, and the risks involved. But it isn’t personal advice. If you’re not sure what’s right for your circumstances, ask for financial advice.

What is leverage?

Leverage has lots of different meanings. But when it comes to investing, it means to either amplify profits or magnify losses – which one hangs on how your investments perform.

In the past, investors and companies would look to borrow money in the form of loans to leverage their positions. Either to buy more shares in a company or to invest into their businesses, with the hope their assets rise in value in the future. Essentially borrowing someone else’s money to boost their own profits.

And while that still happens, not all leverage means a trip to the bank. It’s now possible for investors to juice up their gains, or magnify their losses, through something called leveraged ETFs.

In the investment world, they’re collectively known as exchange trade products (ETPs). But lots of investors use the terms ETF and ETP interchangeably, so we’ll use ETFs for the sake of this article.

How do leveraged ETFs work?

Leveraged ETFs are collective investment funds where lots of investor’s money is pooled together into one investment. They’re designed to multiply the short-term performance of a particular stock market, index or commodity – things like the FTSE 100 index or the price of gold. Like shares, they trade on a live exchange with a live market price.

Let’s take a FTSE 100 2x daily leveraged ETF as an example. It aims to replicate two times the daily percentage change in the FTSE 100 index. If the index goes up by 5%, the ETF would go up by 10%. Likewise, if the index went down by 5%, the ETF would go down by 10%.

That’s an example of what’s called a ‘long’ position. But it’s also possible to take ‘short’ positions through inverse ETFs. When shorting, investors profit when the price goes down, not up.

Most leveraged ETFs use derivatives to track the underlying investment. In the above example, the underlying asset being the FTSE 100 index. Derivatives are essentially a contract between two parties and the price of the contract comes from any changes in the underlying asset value.

Leveraged ETFs are for day trading

At first glance, investing in leveraged ETFs and holding them for longer than a day might not seem like a problem. But when you delve a little deeper, the numbers paint a very different picture.

We’ve already highlighted that leveraged ETFs are for short-term day traders and not long-term investors. That’s because leveraged ETFs reset daily to maintain the same leverage ratio, for example 2x daily, 3x daily, 10x daily. In other words, the slate’s wiped clean at market close and each day’s performance is taken in isolation.

Investors that hold leveraged ETFs for any longer than one day will see their investment’s performance stray away from the benchmark’s performance, thanks to compounded returns.

To see how this works in practise, we can look at the example below.

Normal ETF Leveraged ETF Benchmark
Original investment £100 £100
Day one returns £110 £130 10%
Day two returns £99 £91 -10%
Day three returns £108.90 £118.30 10%
Day four returns £98.01 £82.81 -10%
Total gain/loss -1.99% -17.19% 0%

Figures exclude any investment costs or charges (more on this later).

As you can see, the leveraged 3x daily ETF performed as you’d expect at the end of day one. This ETF aims to replicate the performance of its benchmark by a factor of three times. So the benchmark of +10% has been multiplied by three times, increasing the original investment from £100 to £130.

However, by the end of day four, the gap between the benchmark’s return and the leveraged ETF’s return is significant and has reduced the return to £82.81 compared to the original investment of £100. That’s because the leveraged ETF is compounding its returns whereas the benchmark is resetting every day to maintain the same leverage ratio.

Leverage can work favourably for investors in a forever rising market. But when things start to move both up and down, which they almost always do, losses are bigger and harder to recover from. Although this example uses volatile daily returns, it highlights the issue of holding onto these types of investments for more than one day.

Costs

Leveraged ETFs aren’t cheap either. Costs can eat into returns which can lead to further underperformance. Here are some of the costs you can expect:

  • Management fees – the charge you pay for the ongoing management for leveraged ETF which is taken from the value invested. This is detailed on the factsheet or Key Investor Information Document (KIID).
  • Rollover costs – leveraged ETFs continuously enter and exit derivative contracts as part of the daily rebalancing. This results in interest charges and transaction fees.
  • Dealing fees – the cost of buying and selling leveraged investments through an investment platform or stock broker. Most providers charge a flat rate per trade. Costs can rack up quickly when day trading, especially on smaller amounts.
  • Contango – where the derivatives’ price is higher than the current spot price of the asset. This is common with commodities (things like metals or foods) when their price is expected to rise over time.

The bottom line

Whether you think leveraged ETFs are worth it or not is ultimately your call to make.

Trying to predict which way the market will move in the short term is a bit like guessing which direction the wind will blow tomorrow. You won’t get it right all the time and could even get it wrong every time.

If you’re happy to roll that dice, then you might not think there’s anything wrong with that, but you should only speculate with money you can afford to lose.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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