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What are leveraged ETFs and how do they function?

05 Jan 2023

Exchange traded funds (ETFs) are quite popular in India. There are ETFs on gold and there are ETFs on domestic indices and on global indices. An ETF is like an index fund in the sense that it replicates the index. The only difference is that an ETF is a closed ended fund. Fresh redemptions and investments are not permitted once the ETF is closed. The ETF is listed on the exchange and it can be bought and sold like any stock in the stock market today. So you can only buy an ETF if there is a seller in the market and you can only sell the ETF if there is a buyer in the market. In India, currently, ETFs are required to replicate or mirror a particular index or a commodity. Such ETFs are also required to hold equivalent assets with a custodian and only issue ETF units against that. But then are leveraged ETFs and how do they work?

Understanding the concept of leveraged ETFs
The concept of leverage remains the same. You take a much larger position with a smaller capital. The gap in capital you either make up by borrowing or by equivalent positions in futures. For example, you can buy one lot of Nifty Futures with a margin of just 20%. That is equivalent to 5 times leverage that you are getting. That is the genesis of the concept of leveraged ETFs. A leveraged exchange-traded fund (ETF) is a fund that uses financial derivatives and debt to amplify the returns of an underlying index. Leveraged ETFs are available globally on a lot of indexes, such as the NASDAQ 100 and the DJIA, S&P 500 etc. These funds keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio.

What you need to remember here is that leverage works both ways. When you have leverage to the tune of 3:1, then your profits can be tripled with the same amount of capital However, the downside is that even your losses can triple. So it is not an unmixed blessing that just works one way. IT actually works both ways. But who uses leveraged ETFs? Leveraged ETFs are typically used by traders who wish to speculate on an index, or to take advantage of the index's short-term momentum. The leveraged ETFs are purely meant to ride the short term trend and you use a leveraged ETF only if you are confident and have a high level of conviction in the trend. AS we said earlier, leverage does work both ways and so the risk is admissible only if the higher returns and conviction justify the kind of risk.

Beware of higher expense ratios in leveraged ETFs
A leveraged ETF can have costs as high as 0.8% to 0.9% in the US compared to an index fund that has a cost ratio of less than 6 basis points. You obviously need a lot of conviction to make money out of these ideas. Despite the high expense ratios associated with leveraged ETFs, these are less expensive than short selling, which involves borrowing shares from a broker in order to bet on a downward move and can carry fees of 3% or more on the amount borrowed. The use of paying margin to buy stocks can also become expensive and can also result in margin calls if you start to lose money. In addition, you also have to pay interest on the borrowed amount.

How are futures contracts used in leveraged ETFs?
A leveraged ETF uses futures contracts to magnify exposure to a particular index. Normally, such leveraged ETFs are based on daily change. They could be positive ETFs or Inverse ETFs. It does not amplify the annual returns but the daily changes. For example, in case of a leveraged fund with a 2:1 ratio, this would mean that each dollar of investor capital used is matched with an additional dollar of invested debt. During a given day, if the underlying index returns 1%, the fund would theoretically return 2%. The 2% 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%, the loss would then be 2%.

Leveraged ETFs can also be on the downside. For example, my equity portfolio can be hedged with leverage with 3:1 leveraged futures ETF. 2% fall in the index will lead to a 6% rise in the leveraged futures. It will also work the other way.

How many leveraged ETFs are there globally?
The first leveraged ETF called Pro-Shares was launched in 2006. In the next 12 years since then, the number of leveraged ETFs available in the marketplace has crossed 200. The leveraged ETF offerings include both bullish and bearish exposure to a multitude of sectors, markets, securities and currencies. Leveraged ETFs also provide various levels of exposure, such as 125%, 200% and 300% of a given benchmark's daily performance. As of now, leveraged ETFs are not permitted in India, but may be allowed quite soon.

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