Knowledge Is Power When It Comes To Leveraged ETFs

Leveraged exchange-traded funds are arguably one of the most alluring asset classes on the market today. Novice traders can be seduced by a triple-leveraged ETF, such as the Direxion Daily Gold Miners Index Bull 3X Shares (NYSE:NUGT), which can potentially deliver gains of 20 percent or more in single day.

Leveraged ETFs can be a great investment tool, provided they fit your overall strategy. Just like any investment vehicle, getting the most out of leveraged ETFs comes down to knowing how and when to use them.

What Leveraged ETFs Do

In order to understand how to use leveraged ETFs, you first have to understand what theyre designed to do. Unlike a non-leveraged ETF, leveraged ETFs give you increased exposure to a certain area of the market.

And there is a reason why, at least in the case of Direxion's leveraged ETFs, daily is found in the names. Thats because an ETF such as NUGT is designed to deliver triple the daily returns of its underlying index over the course of one day. Or in the case of an inverse leveraged ETF, such as the Direxion Daily Gold Miners Index Bear 3X Shares (NYSE:DUST), designed to deliver triple the daily inverse returns.

Over the short term these can be great trading vehicles because theyll deliver a greater return than other investment typesespecially in rising markets.

For example, say NUGT has $100 million in assets under management (in reality, it is larger), it must maintain $300 million in exposure to the NYSE Arca Gold Miners Index. If the NYSE Arca Gold Miners Index increases by one percent in a day, NUGT's gross exposure would rise to $303 million (a $3 million increase because were multiplying 1x3), bringing its assets under management to $103 million.

Now that we have a new number for the assets under management, we need to figure out NUGTs new exposure to the index. So 300% of the $103 million under management is $309 million, and the current exposure would be increased from $303 million to $309 million.

Daily Rebalancing

However, you should remember that leveraged ETFs are not buy-and-hold vehicles. This is because of daily rebalancing.

All ETFs rebalance, but leveraged ETFs are required to maintain a certain amount of exposure. This can cause the funds to lose value in the long term, especially in downward markets.

Daily rebalancing has important implications for the performance of the funds for periods longer than a day, notes Direxion. Daily Leveraged Funds exposure is a product of its target magnification and its net assets. Favorable moves in the benchmark push net assets higher, which translates into an increase in exposure by a multiple of the gain in its net assets.

Likewise, if a leveraged ETF's underlying index declines, the ETF's assets can decline, triggering a reduction of exposure in an amount which is a multiple of the decline in the net assets, according to Direxion.

Put another way, as an ETF like NUGT rises, it becomes more aggressive. But as it declines, it becomes more defensive. Heres a hypothetical example.

Lets take that same NUGT example from earlier. If NUGT has $100 million in assets under management (and it must maintain $300 million in exposure to the NYSE Arca Gold Miners Index) a one percent drop in the index would bring NUGT's gross exposure to $297 million (a $3 million reduction because were multiplying 1x3), reducing its assets under management to $97 million.

Then, NUGTs exposure would have to decrease.

Since 300% of $97 million equals $291 million in exposure, the current exposure must be reduced by $6 million from $297 million to $291, according to Direxion.

So you can see how a leveraged ETF can be extremely valuable in the short term, and less so in the long term.

Directionless Markets

Another important point to note regarding the dangers of holding leveraged ETFs for long periods is the erosive impact directionless markets can have on these funds over multiple days or weeks. Put simply, a trader does not want to be holding a leveraged ETF, bull or bear fund, when the market in question can not establish a firm trend.

In volatile markets that exhibit no clear trend or direction, the impact of daily rebalancing can be harmful to the performance of leveraged ETFs over time, said Direxion. Leveraged ETFs respond to gains by increasing exposure to the index, and respond to losses by decreasing exposure each day. Increased exposure in advance of a loss will generate a larger loss, and decreased exposure in advance of a gain will decrease the impact and benefit of future gains for the fund. A continued pattern of this sort will typically cause the decay of the longer term returns of the fund.

At the end of the day, leveraged ETFs can be a great trading tool as part of an active short-term trading strategy, especially if youre looking to capitalize on intraday volatility.