7968 / What is a leveraged ETF?

A leveraged ETF uses financial derivatives and debt to amplify the returns of an underlying index. Leveraged ETFs are available for most indexes, such as the Nasdaq-100 and the Dow Jones Industrial Average. These funds aim to keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio.

A leveraged ETF does not amplify the annual returns of an index; instead it follows the daily changes. For example, in the case of a leveraged fund with a 2:1 ratio, each dollar of investor capital used is matched with an additional dollar of invested debt. On a day in which the underlying index returns 1 percent, the fund will theoretically return 2 percent. The 2 percent return is theoretical, as management fees and transaction costs diminish the full effects of leverage.

The 2:1 ratio works in the opposite direction as well. If the index drops 1 percent, the fund’s loss would then be 2 percent.

Leveraged funds have been available since the early 1990s. The first leveraged ETFs were introduced in the summer of 2006, after being reviewed for almost three years by the Securities and Exchange Commission. The goal of a leveraged ETF is for future appreciation of the investments made with the borrowed capital to exceed the cost of the capital itself.

The typical holdings of a leveraged index fund would include a large amount of cash invested in short-term securities, and a smaller, but highly volatile, portfolio of derivatives. The cash is used to meet any financial obligations that arise from losses on the derivatives.

A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Most derivatives are characterized by high leverage.

There are also inverse-leveraged ETFs that sell the same derivatives short. These funds profit when the index declines and take losses when the index rises.