Leveraged exchange traded funds give investors the opportunity to earn double or even triple the return on an underlying index or ETF. As a result, these funds often have the word "2X" or "3X" in their names ("ultra" and "bull" are also popular monikers).
For example, the ProShares Ultra S&P 500 ETF seeks to deliver twice the return on the underlying S&P 500, while the ProShares UltraPro S&P 500 ETF seeks a return of three times the underlying index.
There are literally hundreds of such leveraged ETFs that seek to outperform the returns on not just stocks but also bonds, commodities, currencies and other tradable assets. And like other ETFs, they are easy and inexpensive to buy and sell, just like any other common stock.
While buying an ETF that promises to double or triple the return on an underlying asset sounds attractive, investors should be aware of the downsides of such an investment.
The most important thing investors need to know about a leveraged ETF is that it does not mimic the underlying index or financial asset over an extended period of time. So, if you think a 2X S&P 500 ETF will return 20% at the end of the year if the S&P 500 itself returns 10%, you'd be wrong.
Leveraged ETFs are only designed to track their underlying index for a single day, after which the ETF reprices and starts again the next day. In essence, they are marked to market each day. As a result, investors who want to trade leveraged ETFs should be aware that this is a very short-term trading strategy.
While it's certainly possible to buy and hold a leveraged ETF for a long period, investors should know that the ETF will not return a precise two- or three-times multiple of the underlying index they're betting on over a long period. That's due to the daily ups and downs of the index and the daily repricing of the ETF.
In addition, like short or inverse ETFs, which also come in leveraged varieties, 2X and 3X ETFs include not only shares in the underlying index they are tracking but also options and other derivatives. This is another reason why there is not a perfect correlation with the underlying asset, which also makes them more risky.
There's another big downside to trading leveraged ETFs, which is that they also magnify losses if the underlying index or asset goes down. Those losses can become even greater if the ETF is held through an extended bear market.
For example, if the S&P 500 falls 2% on a given day, a 2X S&P ETF would fall by 4%, just as it would have gained 4% if the S&P 500 had gone up 2%. But if the S&P fell 2% five days in a row, for a total loss of about 10%, the 2X ETF would be down 20%.
Enhanced ETFs—also known as 2X or 3X, "bull" or "ultra" ETFs—are designed to return double or triple the return on an underlying financial index or asset, such as the S&P 500, the price of gold, or some other asset.
However, because these ETFs are essentially marked to market each day and include financial derivatives such as options, they don't neatly mimic their underlying asset over long periods. Enhanced ETFs also magnify investor losses if the underlying asset goes down. As a result, they're more suitable for professional and experienced investors and traders.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…