What Is a Leveraged ETF and How Do They Work?

Financially reviewed by Patrick Flood, CFA.

Leveraged ETFs allow investors to increase exposure without additional capital outlays. Below we'll explore what leveraged ETFs are, how they work, and why you might want to use them.

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What Is a Leveraged ETF?

A leveraged ETF, as the name suggests, is an ETF (exchange-traded fund) that allows investors to utilize leverage in their portfolio. Leverage simply refers to increasing investment exposure without additional capital outlays. Thus, leveraged ETFs allow you to use leverage without taking on margin, and at degrees greater than what a margin loan would allow.

For example, a 2x leveraged ETF that tracks the S&P 500 seeks to provide 200% of the daily return of the underlying index. That is, if the index increases in value by 5%, the 2x leveraged ETF should increase by 10%. For a 2x leveraged ETF, “2x” and “200%” and “2:1” all refer to the same thing: the leverage ratio. It's not all upside, though. Similarly, if the index falls by 5%, the leveraged ETF falls by 10%. As such, leveraged ETFs provide the potential for greater returns but also the potential for greater losses.

There are leveraged ETFs of many different leverage ratios available for many different indexes, e.g. 2x the S&P 500, 3x the NASDAQ-100, etc.

Now that you know what a leveraged ETF is, let's explore how leveraged ETFs work.

How Do Leveraged ETFs Work?

Leveraged ETFs utilize debt and swaps to attempt to deliver their stated price movement. This borrowing increases transaction costs and management fees of leveraged ETFs. Their expense ratios are usually considerably higher than those of “normal,” unleveraged ETFs. Still, leveraged ETFs are still usually a cheaper form of applying leverage than margin, a collateralized loan from your investment broker. Leveraged ETFs also allow investors to maintain a constant leverage ratio and to avoid margin calls.

Leveraged ETFs are popular among day traders aiming to capitalize on momentum or earnings announcements. There are also inverse leveraged ETFs (-2x and -3x), allowing traders to profit from bear markets, providing what's called a short position. Because of their complex nature involving swaps, debt, and daily rebalancing, leveraged ETFs are likely only appropriate for experienced investors with a high risk tolerance.

Also note that the daily resetting of leveraged ETFs means the fund only provides the stated percentage return relative to the underlying index on a daily basis, not necessarily over the long term. Because of this, volatility of the index can eat away at gains; this is known as volatility decay or beta slippage.

Volatility decay is the boogeyman cited ad nauseam by financial bloggers and analysts as the reason that leveraged ETFs are inarguably unsuitable for holding as long-term investments. And while it's definitely important to understand the potential pitfalls of leverage and the nature of the evil-sounding “volatility decay,” this intrinsic compounding also works in the opposite direction. If the underlying index moves up consistently with decent momentum, volatility decay actually works in your favor. This is why UPRO, the 3x leveraged S&P 500 ETF, has delivered close to 5x the returns of the index since its inception instead of the proposed 3x.

If you’re curious to see the math, I would encourage you to check out this page. It's also actually been proposed that investors should not only diversify across assets but also across time, employing leverage early in one's investing horizon to reduce risk near retirement. I myself utilize long-term leverage in my own portfolio with funds like NTSX (1.5x 60/40), UPRO (3x S&P 500), and TMF (3x long-term treasury bonds).

Now that you know how leveraged ETFs work, let's look at how one might use them in an investment portfolio.

Conclusion – How To Use Leveraged ETFs

Liquidity is an important factor when choosing leveraged ETFs, as low-volume leveraged ETFs are often at risk of closure, and most investors don't hold them long-term.

Again, leveraged ETFs can be used for swing trading, trend following, earnings announcements, or possibly long-term holding if you're so inclined. They may even allow you to beat the market. To see some long-term leveraged ETF strategies in action, check out the Hedgefundie strategy and my designs of a leveraged All Weather Portfolio and leveraged Permanent Portfolio.

I reviewed some of the best leveraged ETFs here.

Thankfully, buying a leveraged ETF is as simple as placing a buy order like with any other security. Most leveraged ETFs are available at M1 Finance. M1 is an ideal choice of broker to use leveraged ETFs because they feature dynamic rebalancing of new deposits and one-click manual rebalancing. These features are extremely useful, as the volatile movement of leveraged ETFs means they can quickly stray from their target allocations. The broker also has zero trade commissions and zero account fees, and offers fractional shares, dynamic rebalancing, and a sleek, user-friendly interface and mobile app. I wrote a comprehensive review of M1 Finance here.

Be sure to read up on the potential pitfalls of using leverage before blindly buying in. Again, leveraged ETFs are better suited for experienced investors. Remember that using leverage – especially in the form of leveraged ETFs – increases portfolio risk and the potential for greater returns, but also the potential for greater losses. Do your own due diligence and read the fine print on these products.

Do you employ leveraged ETFs in your portfolio? Let me know in the comments.

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Disclosures:  I am long NTSX, UPRO, and TMF.

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Disclaimer:  While I love diving into investing-related data and playing around with backtests, this is not financial advice, investing advice, or tax advice. The information on this website is for informational, educational, and entertainment purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. I always attempt to ensure the accuracy of information presented but that accuracy cannot be guaranteed. Do your own due diligence. All investing involves risk, including the risk of losing the money you invest. Past performance does not guarantee future results. Opinions are my own and do not represent those of other parties mentioned. Read my lengthier disclaimer here.