Sitting atop this year’s performance gainers are leveraged ETFs. These are funds that use a combination of debt and derivatives to magnify their performance. Are leveraged ETFs right for you?
Before tackling this question, let’s examine key trends within this arena.
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Among this year’s best ETFs are funds concentrated in semiconductors (NYSEARCA:SOXL), homebuilders (NYSEARCA:NAIL), and Chinese internet stocks (NYSEARCA:CWEB).
While leveraged ETFs are sometimes targeted by critics with biased or one-way viewpoints, the truth is that leveraged ETFs offer financial flexibility and alternatives for demanding investors and traders. Let’s analyze four benefits of leveraged ETFs.
No Margin Borrowing RequiredUsing a brokerage margin account is a common method of obtaining leverage. While it’s easy to focus on all the good things that can happen when you borrow money from your broker to buy securities, a lot can go wrong.
Let’s first begin with retirement accounts like traditional and Roth IRAs.
If you try to post IRA assets as collateral for margin trading within a retirement account, the IRS views it as a taxable distribution, which would subject the IRA owner to potential taxes and penalties regardless of whether the money stays invested or not. For that reason, many brokerage firms disallow margin borrowing in IRAs along with other qualified retirement plans. And even if you find a brokerage who does allow you to trade with margin inside your retirement account, you will put your money at significant tax risk if you run afoul of the strict trading rules. The tiniest slip-up could cause your retirement account to be taxed and penalized!
In contrast, leveraged ETFs give investors a powerful alternative to margin trading.
First, leverage ETFs allow you to customize the amount of leverage you desire. For example, if you like small cap stocks (NYSEARCA:IWM) but if you’re not too keen on using lots of leverage, you’ve got choices. Instead of using a 200% (NYSEARCA:SAA) or 300% (NYSEARCA:TNA) daily leveraged small cap ETF, you can go with a toned down version like the Direxion Daily Small Cap Bull 1.25X Shares (NYSEARCA:LLSC), which uses just 125% daily leverage.
Here’s another important difference about leveraged ETFs vs. margin: With leveraged ETFs you cannot lose more than your original investment. And that’s a significant advantage compared to a margin borrowing because you can definitely lose more money than you deposited in a margin account if the securities you buy sink like the Titanic. And of course, if that ever happened, you’d still be on the hook for repaying your margin loan with interest.
Less Capital at RiskLet’s assume you like the S&P 500 and decide to use the SPDR S&P 500 ETF (NYSEARCA:SPY) for your market exposure. Obtaining 100 shares will cost you around $28,500. Instead of putting that full $28,000 and change at risk, you have several alternatives.
The ProShares Ultra S&P 500 ETF (NYSEARCA:SSO) or Direxion Daily S&P 500 Bull 3X Shares (NYSEARCA:SPXL) give you the same S&P 500 exposure, but with 200% or 300% daily leverage. That means instead of putting up the full $28,000 and change to get dollar for dollar exposure to the S&P 500 with an unleveraged ETF like SPY, you could put up half that amount of money or less to get similar exposure, but with less capital at risk.
Keep in mind that leveraged ETFs are designed to mimic a daily multiple (usually 2x or 3x) of their underlying index and over longer periods of time that multiple is likely to be different. In some cases, the daily multiple might not even be achieved, thereby creating “tracking error.”
Eliminate Single Stock RiskThe ability to eliminate the inherent risks associated with investing in individual stocks is among the top reasons to go with ETFs – leveraged or not.
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If you like the energy sector, for example, but want to avoid the risk of single-stock blowups, you could choose the basket approach of owning the Energy Select Sector SPDR ETF (NYSEARCA:XLE). And if you want to amplify your return on the bullish side, you can go with leveraged fund like the Direxion Daily Energy Bull 3x Shares (NYSEARCA:ERY). If the collective performance of energy stocks tied to the index rises 1% on any given day, ERY should be up 3%.
ETFs allow you to focus on the bigger market trends happening vs. the micro-economic trends impacting individual stocks. Moreover, it allows you to spend less time researching individual companies and to focus on your overall investment strategy.
Capitalize on Falling MarketsTo sell stocks short, you need to have a margin account. As we already discussed, this pretty much rules out shorting within a qualified retirement account. But even if you short individual stocks inside a taxable account, you bump into similar financial risks of losing more than you invest, leaving you on the hook with margin debt and interest.
Inverse ETFs allow you to capitalize when financial markets are falling. And since leveraged ETFs come in many flavors, it also means you’re not limited to just stocks – but you can trade other markets that might be declining like bonds, real estate, currencies, and commodities.
For example, if you feel interest rates are on the rise and will be substantially higher in the future, it would be obviously bad news for bonds with long-dated maturities. A leveraged ETF like the Direxion Daily 20+ Year Treasury Bear 3X Shares (NYSEARCA:TMV) would be one way to play this trend. TMV is designed to increase if the value of long-term U.S. Treasuries falls. And since TMV aims for triple (300%) daily opposite leverage, it means that if long-term U.S. Treasuries declined by 1% on any given day, TMV should be up 3%.
Summary Despite criticisms, leveraged ETFs give investors and traders many viable alternatives for amplifying gains, putting less trading capital at risk, and even profiting when markets decline.