Leveraged ETFs; these relatively volatile instruments have become hugely popular over the last year. Internet discussion forums and just about anywhere else that investors gather are buzzing with questions and opinions regarding these relatively new trading tools.
Popular opinion runs the gamut from dire warnings of ones portfolio being quickly chopped to pieces by their use to rave reviews on how these tools were used to quickly grow profits and saving ones account. The truth lies, not in the tools themselves, but how they are used. It is akin to comparing an axe to a chainsaw. The axe is dangerous in the wrong hands, but not nearly as hazardous as a chainsaw in untrained hands. The axe will do the same job as the chainsaw, albeit slower and with more effort. However, when operated by a trained and cautious user, the chainsaw will produce tremendously greater results than the axe. Leveraged ETFs are the chainsaw of the ETF world. This article will explain leveraged ETFs and provide a basic understanding on how they can be safely used to enhance portfolio performance.
Introduced in 2006, Leveraged ETFs are Exchange Traded Funds that provide greater than one to one exposure to the underlying index. The exposure is generally 2x, however 3x leveraged ETFs have been recently launched. It is important to note that it is 2x or 3x the daily movement of the underlying and not 2x or 3x leveraged the yearly gains/losses of the index.
In addition, ETFs marketed as 3x are generally only actually 2.5x leveraged. In other words, for every point the underlying index moves during the day, a leveraged ETF moves twice or 2.5x that amount. Examples of popular 2x leveraged ETFs include the ^DXD^,^QID^, ^UGL^, ^ULE^, ^RSU^ and ^RRY^. Examples of 3x leveraged ETFs includes Direxion Monthly S&P 500 Bull 2X ^DXSLX^, Direxion Monthly S&P 500 Bear 2X ^DXSSX^, and Direxion Monthly Small Cap Bull 2X ^DXRLX^.
I am certain many of you are asking just how these ETFs achieve leverage of this magnitude. Without going into complex fund construction mathematics, simply stated, it is done with a mixture of options, index futures and swaps to achieve the desired results. Unfortunately, this financial stew requires a daily rebalancing to maintain the desired leverage. This rebalancing results in an extra management and interest cost that adversely affects profits. This is the primary complaint against the actual structure of leveraged ETFs. The other scuttlebutt generally involves traders’ issues with money management and biting off more than is prudent when trading these instruments. Leveraged ETFs are a powerfully positive tool when used with discretion and caution. When used without proper money management, they can quickly lead to portfolio damnation.
David Goodboy is Vice President of Business Development for a New York City based multi-strategy fund. Read his blog at marketsurfer.com.