Since youre reading this, its safe to assume you are curious or unsure about leveraged ETFs. The fact that you want to learn more about how these assets function and whether theyre compatible with your own investment style is a good indication that you have at least the appropriate resolve to properly utilize leveraged ETFs.
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The reason you should question whether these instruments make sense for you is because leveraged ETFs are not for every investor. They require active oversight and involvement on the part the investor. Even when properly handled, leveraged ETFs can introduce risk into your portfolio, and are therefore not suited for investors entirely averse to risk.
Of course, leveraged ETFs do have significant advantages for those who fully appreciate the role these assets play as a complement to their core investments. Leveraged ETFs are designed to provide magnified returns on (or against) the short-term movements of a particular index. Breaking down why and how that works is a critical first step in determining whether you should use leveraged ETFs in your everyday investing.
High Exposure, High Risk
A vital component to leveraged ETFs is, of course, the high degree of leverage they provide investors. Leveraged ETFs are built to maximize returns on directional market moves over a single trading day. Traders of these funds should expect a high amount of exposure in the securities they contain, as the fund is required to generate the stated daily return objective. However, with the potential for increased daily returns of 200% to 300% of the underlying index, comes the equal potential for loss if the index moves in an unfavorable direction.
Adding to the exposure risk, leveraged ETFs are rebalanced daily in order to match their stated daily investment objectives. This means that, as the underlying index moves in any direction, the ETFs net assets are altered by the same degree as its return multiple. In the case of a 3x leveraged ETF, if the underlying index moves up 1%, the ETFs gain 3%. If the underlying index falls 1%, the ETFs loses 3%. This rebalancing is tailored to respond aggressively to gains and defensively to losses, but also makes volatile or unanticipated movements in an index extremely risky for investors.
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All of this makes it necessary for investors to constantly manage the leverage ETFs in their portfolio. In order to use leveraged ETFs successfully, you must be able to manage your position in the ETF and willing to make frequent changes in tandem with market movements, to manage your exposure levels.
Daily, Not Yearly, Investment Objectives
This brings us to one of the most critical yet misunderstood components of leveraged ETFs: they are not intended to be long-term investments.
The investment objectives outlined in a leveraged ETFs prospectus a detailed summary of an ETFs goals, risks, fees, and overall strategy can often include a target performance metric of 200% to 300% of the underlying indexs daily performance. The key word to pick out from the objective statement is daily. Leveraged ETFs will not track double or triple the returns of the indexes they cover over a long period.
Again, rebalancing has much to with this. Think of it this way: a 3x leveraged ETF aims to meet its daily benchmark performance on its index. Therefore, a 1% rise in the indexs value will result in a 3% increase in the ETFs exposure after rebalancing. That means, following that increase in asset exposure, an ensuing 1% drop in the index, and 3% drop in the ETF, will equate to a net loss in value of the original investment by .09%. By that same token a 1% drop in the index followed by a 1% gain after rebalancing will, given the -3% rebalancing of the funds assets after the index dropped, equates again to a net loss of .09%.
Long term, these movements may break even, or they may lead to a loss. The point is that theres no guarantee on how a leveraged ETF will behave on an extended timeline, and they are not built to deliver extended results.
Built For Agility
With the risk for loss and the need for constant management in mind, it is important to expand on how leveraged ETFs are specifically built to allow frequent traders quick and outsized exposure to indexes with clear short-term directionality.
While it is important to remain aware of how leveraged ETFs are not intended to function, experienced and hands-on investors can earn quick income and supplement their primary investments by properly managing these devices. Deliberate and well-timed trades are a part of that, as is knowledge of how the index each ETF covers traditionally moves, and an acceptance of the risks that could result in a loss.
Regardless of your investment experience and trading habits, if you are new to leveraged ETFs, it is recommended you seek the advice of an investment professional before making an investment.
2017 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.