Getting Started With ETFs

February 24, 2022

What are Leveraged ETFs?

Certain products seek to deliver daily results that correspond to the daily change in the index multiplied by the target leverage factor. For example, the ProShares UltraPro S&P 500 (UPRO) seeks daily investment results that correspond to three times (300%) the daily performance of the S&P 500 Index. If the S&P 500 gains 1% during a trading session, UPRO would be expected to appreciate by approximately 3% over the same time period. But the relationship between the leveraged ETF and the underlying index holds only for a specific time period—in the case of UPRO, a single trading session. When leveraged ETFs are held for a period of time either longer than or shorter than the rebalancing period, returns are subject to the impact of compounding. In order to understand the risk/return profile of leveraged ETFs, as well as the potential suitability for a client, it’s important to understand the impact that the daily reset of exposure has on the product.

There are several ways for daily leveraged ETFs to achieve the amount of exposure necessary to deliver these returns. While the exact blend of securities used may vary from fund to fund, most of these products use various derivatives to accomplish the stated objectives. For example, a 2x long S&P 500 ETF may use a combination of equities, futures and swaps to essentially double its exposure. A fund with $100 million in assets might invest $80 million in the underlying assets of the relevant benchmark (in this case the S&P 500), leaving $20 million in cash. A portion of this cash could be used to purchase S&P 500 futures contracts— exchange-traded derivatives that provide exposure to a benchmark without direct ownership. A futures contract is essentially a standardized contract between two parties that agree to buy (and sell) an underlying index at a future date at the market price. The buyer of a contract has a long position in the underlying, while the seller has a short position. A portion of the cash held by the fund could be used as collateral for the futures position.

In addition, a leveraged ETF may enter into an index swap agreement with a counterparty to increase its exposure to the underlying index. Swaps are customized agreements between two counterparties to exchange two sets of cash flows over a specified period of time. In an equity index swap, one party generally pays cash equal to the total return on the underlying index, while the other pays a floating interest rate.

By investing in a combination of these assets, a 2x leveraged ETF can establish $200 million of exposure with $100 million in assets (Figure 1).

The process for constructing a -2x leveraged ETF has some similarities. Because such a fund would be designed to deliver exposure equivalent to a multiple of the inverse return on a benchmark, it could keep a significant portion of its assets in cash, which would be used as collateral for futures and swaps contracts that would increase in value if the related benchmark declined (Figure 2).

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