What Is a Leveraged ETF? Everything You Need to Know

Leveraged ETFs are much riskier than traditional exchange-traded funds, but they can produce much higher returns. If used properly, these unique investments can be used to amplify portfolio returns or to hedge against market downturns. 

Find out how leveraged ETFs work, and if they’re right for your investment strategy. 

What Is a Leveraged ETF? 

A leveraged ETF is an exchange-traded fund that uses debt or financial derivatives as leverage to amplify the returns of a benchmark index, such as the S&P 500. Leveraged ETFs can produce significant short-term gains, such as 2x or 3x the performance of their benchmark, but investors should note that short-term losses can also be amplified.

How Do Leveraged ETFs Work? 

Investors can begin learning how leveraged ETFs work by comparing them to traditional ETFs. For example, a traditional ETF that tracks the S&P 500 will seek to match the index returns on a 1:1 basis by holding the securities in the index. However, a leveraged ETF may seek to produce returns at a 2:1 or 3:1 ratio, double or triple the returns, respectively. 

To amplify the daily returns of its benchmark index, a leveraged ETF doesn’t hold the securities found in the benchmark but will use debt or financial derivatives, such as options contracts, to amplify the benchmark returns. The daily return amplification strategy is important to note, as it does not typically translate to the amplification of long-term returns.

Leveraged ETF Example

For a specific example, let’s say an investor buys shares of a 2x S&P 500 leveraged ETF. If the S&P 500 gains 1% on the day, the 2x S&P 500 ETF would be expected to produce a 2% return. However, leveraged ETFs work in the opposite direction as well. So, if the S&P 500 declined by 1% in a day, the leveraged ETF would be expected to produce a return of -2%. 

Since leveraged ETFs seek to amplify the daily returns of a benchmark index, the typical holding period is not commonly more than one or two days. 

What Is an Inverse Leveraged ETF? 

An inverse leveraged ETF has the opposite strategy of a leveraged ETF in that it attempts to produce positive returns when its benchmark index produces negative returns. Therefore, inverse ETFs are designed to enable investors to make money when the benchmark index declines. 

Like leveraged ETFs designed to amplify returns, an inverse ETF uses various derivative products, such as options, to achieve its results. Inverse ETF strategies are typically designed to have a 2x or 3x performance move in the opposite, or “inverse,” direction as the underlying benchmark index. 

For example, if an investor bought a 2x inverse leveraged S&P 500 ETF, and the S&P 500 index declined by 1% in one day’s trading, the inverse ETF would be expected to gain 2% that day. 

What Is a Single-Stock Leveraged ETF? 

A single-stock leveraged ETF is an exchange-traded fund that uses derivatives to amplify returns or to provide inverse exposure to highly traded individual securities. For example, the AXS TSLA Bear Daily ETF (TSLQ) is an inverse single-stock ETF that provides -1x exposure to Tesla stock. 
 
For example, if an investor owns the TSLQ ETF and Tesla stock falls in price by 1% during daily trading, TSLQ would be expected to rise in price by 1%. Keep in mind that the opposite is also true, where TSLQ would fall in price if Tesla shares rose in price. 

What Are the Pros and Cons of Leveraged ETFs? 

Leveraged ETFs are unique in that they can produce outsized gains for investors, but they can also produce outsized price declines. Therefore, investors thinking of investing in leveraged ETFs should carefully weigh the benefits and risks before buying. 

Pros

• High return potential: Leveraged ETFs can produce double or triple the daily returns of a benchmark index. 
• Simple alternative to derivatives: Since leveraged ETFs use financial derivatives to achieve their objectives, investors gain indirect access to options or futures contracts without having to own them. 
• Easy to trade: Like a traditional ETF, a leveraged ETF can be bought and sold like a stock on an exchange. 

Cons

• Amplified market risk: Since leveraged ETFs are designed to amplify the returns of a benchmark index, the downside risk is equally amplified. For example, a 2x leveraged ETF may double the daily return of a benchmark index, but it may also double the decline. 
• Long-term tracking: The use of financial derivatives enables leveraged ETFs to tightly track and amplify the returns of their benchmark indices on a daily basis, but they do not accurately produce the same results over longer periods of time.
• High fees: Compared with traditional ETFs, leveraged ETFs require a higher degree of management from trading activity; therefore, their expense ratios are also typically higher. 

Bottom Line on Leveraged ETFs

Leveraged ETFs are an example of investments that have the potential to produce extremely high returns, but the market risk taken by investors is also extremely high. Many leveraged ETFs have a 2x, and some have a 3x leverage strategy, which means that returns can respectively double or triple the daily returns of the benchmark index. However, price declines can also be doubled or tripled, which creates an excessive degree of market risk.

Because of their unique design, benefits and risks, leveraged ETFs may be used by some short-term traders or advanced money managers; however, they are generally not appropriate for beginning investors.