Leveraged ETFs: What You Need To Know

A quiet revolution has taken place in financial markets over the last 25 years.  The funny thing is that many investors don’t even realize that this revolution has taken place.  That’s the interesting fact about some revolutions, when you are living through the revolution it can be difficult to realize what is happening.

ETF bloomberg1

The revolution I am talking about is the rise of Exchange Traded Fund or ETF’s.   Today ETF’s account for nearly 1/3 of all stock exchange volume with over a billion shares per day traded in 2014.

etf growth

ETF’s allow everyday investors to access global markets in their regular stock trading account.  There is no longer a need to open up a variety of different accounts to diversify across markets.

Perhaps the most exciting revolution within ETF growth story is the invention of triple leveraged ETF’s.  Not only do these ETF’s provide investors massive diversification, the inherent leverage is an extremely powerful tool. 

However, at the same time, these leveraged tools are full of dangers for the uneducated investor.  Believe it or not, during the market volatility of 2009, some triple leveraged ETF’s actually moved in the opposite direction of their design!

While this was a rare occurrence, there are certain things that you need to know to make triple leveraged ETF’s work for you rather than against you.

First, let’s take a closer look at ETF’s themselves.

According to Nasdaq, first launched in the United States in 1993, Exchange Traded Funds (ETFs) are funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its underlying index. The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index, but simply replicate its performance. In other words, they don’t try to beat the market, they try to be the market.

etf bloomberg

ETFs are designed to combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors can purchase ETF shares on margin, short sell shares, or hold for the long term.

The purpose of an ETF is to match a particular market index, leading to a fund management style known as passive management. Passive management is the chief distinguishing feature of ETFs, and it brings a number of advantages for investors in index funds. Essentially, passive management means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index.

Triple Leveraged ETF’s

Direxion is the primary firm that offers the tripled leveraged ETF products.  They first introduced the so-called triple leverage index fund in 2006.

direxion

While these ETF’s are called triple leveraged, the reality is that most of them are leveraged 2.5%. What this means is for every point the underlying instrument/index moves, these products move 2.5 times that amount.  For example, if the SP500 moves one point up, the ETF moves 2.5 points.  As you can imagine this leads to wild gains and losses for traders speculating with these tools.

 

Why would a trader use these types of products?

The simplest reason traders would add these products to their portfolio of tools is to magnify gains when speculating in the market.  Less capital goes further, more bang for your buck, so to speak.  However, its critical to ALWAYS keep in mind that this kind of leverage, or any leverage for that matter, is a two edged sword.  You can lose just as fast as you can win when trading these volatile products.  Several of the other reasons tripled leveraged ETF’s make sense include:

leverage

 

  1. Hedging—Purchasing tripled leverage ETF’s inversely correlated to your holdings will allow you to correctly hedge against adverse moves with less capital outlay than hedging with less levered instruments.
  2. Portable Alpha—This hedge fund sounding strategy is simply adding diversification while maintaining the same exposure.   Leverage is utilized to free up capital with the proceeds invested in non-correlated investments to decrease volatility. The tripled Levered ETF’s are ideal tools for this goal.
  3. Long Short Relative Value—A great tactic to use to smooth volatility in your portfolio. The concept is similar to pair trading where a long position is taken in the ETF that is believed to be headed up, and a short position placed in an ETF thought to be heading downward.  The tripled leverage ETF’s allow this strategy with less cash outlay for the same exposure.

 

The Dangers

Beyond the obvious dangers of high leverage, triple leveraged ETF’s contains hidden dangers.  The least understood and what gets many investors in deep trouble with these products is the fact that they are rebalanced on a daily basis to maintain the leverage.

The rebalancing causes the ETF to incur fees and costs which in turn result in the ETF not tracking the underlying products exactly over the long term.  Triple-leveraged ETF’s are specifically designed for day trading and not long-term holding due to this fact.   Many investors get burned by this fact by trying to hold triple leveraged ETF’s for the long term.

danger

Another problem can be their popularity during extraordinary events. One example is that The Wall Street Journal reported that Direxion’s Financial Bear 3X traded 23 million shares on February 25th 2009 with only 2 million shares issued at the time.  One can extrapolate that the holding time averaged just 34 minutes.

As was pointed out earlier major problems surfaced during 2009 with triple leveraged ETF’s.   Due to the extreme volatility, several produced returns the opposite of what they were designed to do while others greatly disappointed investors with lack luster performance over the longer term.

Basically, many investors did not read the fine print stating that the returns are daily based on the underlying instruments.  As in any leveraged instrument, daily rebalancing is required to keep the product tracking the underlying.  It is due to this rebalancing that the cumulative returns do not match the daily returns.  In other words, if you hold leveraged ETF’s for more than a day, some unexpected and even crazy things can happen.

As I mentioned, at the start of this article, there are many sophisticated strategies that can be utilized with these tools.  Tripled leveraged ETF’s can enhance your portfolio but they can easily destroy it, if used in the wrong way.  Every trader should look closely at these offerings but do so with caution!

The Key Takeaways

ETF’s have truly revolutionized the stock market.  No longer do investors need to search the world to trade a wide variety of indexes, commodities and baskets of stocks.  ETF’s make this process seamless with a single instrument.

Triple leveraged ETF’s are the bad boys of the ETF world.  The leverage employed makes them extremely profitable yet incredibly dangerous in the wrong hands.

Triple Leveraged ETF’s are designed to be day traded only.  It is very dangerous on multiple levels to hold Tripled Leveraged ETF’s overnight due to the rebalancing that takes place on a session by session basis.  These ETF’s may not follow the underlying instruments on a long term basis and can do very unexpected things depending on the current volatility level.