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Stocks & Commodities V. 27:12 (68-70): Working Money: Leveraged ETFs by John Devcic

tRADER’S NOTEBOOK

Leveraged Etfs
the new kids on the block. They
are becoming popular nonetheless,
promising double or triple the return of
a normal Etf. Investors are beginning
to add these to their portfolio. Is a
leveraged Etf the right fit for your
portfolio?

Leveraged ETFs
Leveraged Etfs were first introduced in
2006 by ProShares. That first leveraged
Etf known as Ultra ProShares is
still around today. The concept of
a leveraged Etf is pretty easy to
understand. Leveraged Etfs track an
index, so they do not outperform one.
While tracking the index, a leveraged
Etf is designed to double or triple the
return of that index for that trading day.
Yes, that’s right! Say the Dow Jones
Industrial Average (Djia) goes up 1%
tomorrow and you own the leveraged
Etf that tracks the Djia; you would
have made a 2% return. There are two
important concepts about leveraged
Etfs that need to be understood:
1 A leveraged Etf is designed to
double or triple the return of the
index it tracks, up or down. The
leverage works both ways. If you
are correct in your analysis and
believe a particular market is
going to go up, you could indeed
double your return. If you are
wrong, however, things are going
to get bad quickly.

2 The second important concept to

remember about leveraged Etfs
is they are designed to double
If you’re into short-term index strategies, a or triple the return of the index
leveraged ETF could be just what you need. they track on a daily basis. These
leveraged Etfs are not meant to
by John Devcic be buy & hold instruments. It
is important to differentiate the

E
xchange traded funds (Etfs) have grown by leaps and bounds since idea of doubling or tripling a
their introduction. Embraced by institutional investors as well as self- daily return versus doubling or
directed traders and investors, Etfs are almost as widely accepted an tripling a long-term return. Most
investment vehicle as mutual funds. Leveraged Etfs are no longer self-directed investors look at

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 27:12 (68-70): Working Money: Leveraged ETFs by John Devcic
investments for the longer-term time horizon. The nature
of leveraged Etfs is not conducive to investing for the
long term; they are strictly short-term investment plays.
The concept of leveraged Etfs is easily understood,
but the complexity lies in how these leveraged Etfs
actually work.
Under the hood
Leveraged Etfs use derivatives such as index futures,
equity swaps, and index options in order to double or triple
the return of the market they track. I mentioned earlier that
leveraged Etfs double or triple the return of the market they
track daily because they reset it daily. Management will have
to hold an equal amount of debt and equity at all times.
Say a fund has $200 million invested. It will have to go
out and borrow that exact same amount. That $400 million
in the fund will be invested in the index it is set to track. In
order to borrow that $200 million, the fund uses derivatives.
Every single trading day, the assets in the fund will either go
up or down. This change causes the leverage ratio to change.
This means total assets are not equal to total debt. By the end
of the trading day, the fund’s leverage has to be reset.
Simply put, if the fund tracks go down, the fund will have
to sell shares in order to reduce its debt level. If the index
goes up, the fund will have to buy shares. A leveraged Etf
will incur a lot of expenses from this daily resetting. Over
a long period of time, the performance of these leveraged
Etfs will diverge from the index that the fund was set out to
track. This is why a long-term approach to these indexes is a
gigantic mistake. It is best described in a prospectus: “Over
the course of a year, a fund using triple leverage for a long
exposure to an index experiencing 20% volatility would
lose 11% of its value even with no net change in the index.”
Clearly, this is not an Etf you can buy and hold as a long-
term play.
The good, the bad,
and the ugly
The good:
There’s no need for margin since margin is already built into
the fund. If you do use margin to buy shares of this type of
Etf, you need to realize that you change the leverage from
2x or 3x returns to 4x and 6x returns, respectively. You are
using leverage without having to rely on options or margin.
n Short-term trading — If you are tracking an index and
believe the index will go higher or lower that day, you can
use leveraged Etfs to quickly capitalize on this short-term
move.
n Using derivatives — Most self-directed investors and
traders will not be able to add the power of derivatives to
their portfolio without a lot of hassle. Leveraged Etfs allow
you to profit if your analysis is correct using derivatives.
Copyright (c) Technical Analysis Inc.
Leveraged ETFs use
derivatives in order to double
or triple the return of the
market they track.
The bad:
These funds will incur lots of management fees due to the
daily rebalancing of the fund that other Etfs just won’t
have.
n Leveraged Etfs can be dangerous — If you are an
investor who doesn’t understand the potential for losses in
these Etfs, you could see massive losses quickly even if the
tracked index is slightly down or trading sideways.
n Thinly traded — Some leveraged Etfs are not heavily
traded, so closing a position could be a problem. It is
critical that a potential investor look at trading volumes of
the leveraged Etf that he or she is interested in. With new
leveraged Etfs appearing all the time, you will need to keep
a close eye on trading volumes.
n Short-term play — These are Etfs that, because of daily
resetting, can cause compounding losses to mount if an
investor decides to buy and hold onto a losing position.
Even if the index that the leveraged Etf is tracking is trading
sideways, you could still see a loss in your leveraged Etf.
Losses can mount fast if the investor is not careful.
The ugly:
Due to their popularity, leveraged Etfs have come under
scrutiny recently from both politicians and financial
regulators. This is all in an effort to protect an investor who
may believe these funds are something they are not. They
are not long-term buy & hold Etfs. If an index is up 10%
for the year, this does not mean the Etf will be up 20%
or 30%. Both the Securities and Exchange Commission
(Sec) and Financial Industry Regulatory Authority (Finra)
have warned individual investors that these leveraged Etfs
are not buy & hold instruments. They feel that while the
current prospectuses do indeed point out this fact, they feel
that more information and a clearer message needs to be
delivered by these leveraged Etf companies. Recently,
Massachusetts has decided to review the sales practices of
the leveraged Etfs.
Think short term
Leveraged Etfs have been used by savvy daytraders and
investors since 2006. Self-directed investors and traders who
plan on incorporating leveraged Etfs into their investment
strategy need to learn all they can.
The most important thing to remember about these
leveraged Etfs is that they are not, nor should they be, used
as a long-term play. They are designed to be used in short-
Stocks & Commodities V. 27:12 (68-70): Working Money: Leveraged ETFs by John Devcic

tRADER’S NOTEBOOK

term trading strategies. Do not expect a leveraged Etf to John Devcic is a market historian and freelance writer.
return double or triple the index it tracks over the long term.
Leveraged Etfs are a knife that cuts both ways. Leverage is Suggested reading
a wonderful tool to have because wins become bigger, but Devcic, John [2009]. “Get Shorty,” Technical Analysis of
so do losses. Caution is the rule when it comes to leveraged Stocks & Commodities, Volume 27: November.
Etfs. If you are not interested in buying and selling these
Etfs on a daily basis, you should not be involved.
That said, if you have a short-term index strategy,
a leveraged Etf can be a fantastic tool. All powerful
investments need to be understood before being used S&C
This article — and articles like it — can be
appropriately. found online at www.working-money.com.

Copyright (c) Technical Analysis Inc.

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