Leveraged ETFs

Leveraged ETFs are highly speculative short-term investments, and are very different from most other ETFs. These ETFs use leverage – they borrow to increase the amount that they can invest in the market – and are riskier than funds that do not. They aim to double or triple the daily return of a specified index. Sometimes they are designed to move opposite to the market (this is called an inverse ETF). They are best suited to institutions and sophisticated investors who trade daily and can afford to take on the added risks.

Risks of leveraged ETFs

While leveraged ETFs carry the same risks as other ETFs, they have additional risks that make them highly speculative.

Your losses are multiplied

As with any leveraged investment, your potential gains are multiplied – but so are your losses if the index turns the other way. If the ETF aims to double or triple the return of the index it’s tracking, and the market moves in the wrong direction, your losses will be doubled or tripled. For example, if the ETF’s objective is to triple the index, and the index drops by 10%, the share value of the ETF will fall by 30%.

You’ll likely lose money over the long term

For periods longer than a day, you can’t assume you will earn 2 or 3 times or minus 2 or 3 times the return of the underlying index. The objective of these funds is to double or triple the daily return of an index. This means the ETF must rebalance — or “releverage” — its position every day to keep the amounts borrowed in line with the actual stock owned.

Over a longer investment period, the constant leverage and rebalancing results in fund returns that don’t meet the daily objectives of a fund. If returns vary widely from day to day, over time you’ll lose money even if the underlying indexIndex A benchmark or yardstick that lets you measure the performance of a stock market, part of a stock market or a single investment. Examples: S&P/TSX, S&P/TSX Canadian Bond Index.+ read full definition breaks even.

Example – Let’s say you buy a leveraged ETF that aims to double the return of a certain index on a given day:

  • You buy the ETF for $100 per shareShare A piece of ownership in a company. A share does not give you direct control over the company’s daily operations. But it does let you get a share of profits if the company pays dividends.+ read full definition, and the index is at 10,000.
  • The next day, the index is up 10% to 11,000. Your ETF shares increase by 20% (2 times the index) to $120 that day. You decide to hold on to your shares.
  • The following day, the index falls back down to 10,000, a decline of 9.09% from 11,000. The ETF falls by 2 times the index, or 18.18% that day.
  • The ETF’s shares are now worth $98.18 ($120.00–$21.82).

Even though the index breaks even over the 2-day period, you’d lose money on the ETF. And that’s before paying fees or commissionsCommissions What you pay to a broker or agent for their services. Often called a “sales commission”. For example, you pay a fee to someone who buys or sell stocks or real estate for you.+ read full definition.

Leveraged ETFs don’t own their portfolios

Leveraged ETFs don’t own the leveraged portfolios that they provide exposure to. Instead, they “borrow” assets from a counterparty, usually a big bank or investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition firm. There’s a risk that these ETFs will not provide the expected returnExpected return Estimated value of your investment in the future. Tells you the overall profit you might expect – either as income (interest or dividends), or as capital gains (or losses). Often expressed as a percentage.+ read full definition if the counterparty goes bankrupt.

As with any leveraged investment, your potential gains are multiplied – but so are your losses if the index moves the other way. You can never lose more than the amount of your original investment, but you can lose all of it.

Warning

Leveraged ETFs are highly speculative short-termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition investments. They are not appropriate for investors who are planning to hold their investment for longer than a day – especially in volatile markets.

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