Leveraged ETFs are highly speculative short-term investments. They are best suited to institutions and sophisticated investors who trade daily and can afford to take on the added risks.
While leveraged ETFs carry the same risks as other ETFs, they have 4 additional risks that make them highly speculative. You'll likely lose money if you hold a leveraged ETF longer than a few days, especially in volatile markets. You can never lose more than the amount of your original investment – but you can lose all of it.
4 key risks
1. Your losses are multiplied
As with any leveraged investment, your potential gains are multiplied – but so are your losses if the index turns the other way. If the ETF aims to double or triple the return of the index it’s tracking, and the market moves in the wrong direction, your losses will be doubled or tripled. For example, if the ETF’s objective is to triple the index, and the index drops by 10%, the share value of the ETF will fall by 30%.
2. You’ll likely lose money over the long term
For periods longer than a day, you can’t assume you will earn 2 or 3 times or minus 2 or 3 times the return of the underlying index. The objective of these funds is to double or triple the daily return of an index. This means the ETF must rebalance — or “releverage” — its position every day to keep the amounts borrowed in line with the actual stock owned.
Over a longer investment period, the constant leverage and rebalancing results in fund returns that don’t meet the daily objectives of a fund. If returns vary widely from day to day, over time you'll lose money even if the underlying index breaks even.
Example – Let’s say you buy a leveraged ETF that aims to double the return of a certain index on a given day:
- You buy the ETF for $100 per share, and the index is at 10,000.
- The next day, the index is up 10% to 11,000. Your ETF shares increase by 20% (2 times the index) to $120 that day. You decide to hold on to your shares.
- The following day, the index falls back down to 10,000, a decline of 9.09% from 11,000. The ETF falls by 2 times the index, or 18.18% that day.
- The ETF’s shares are now worth $98.18 ($120.00–$21.82).
Even though the index breaks even over the 2-day period, you’d lose money on the ETF. And that’s before paying fees or commissions.
3. You may pay taxes on capital gains distributions
Index ETFs are considered relatively tax efficient. Their holdings do not change frequently, which means they have little or no capital gains distributions each year. This is not the case with leveraged ETFs. The daily rebalancing of the portfolio to meet the leverage goals may create potentially taxable capital gains that would be passed on to investors.
4. Leveraged ETFs don't own their portfolios
Leveraged ETFs don’t own the leveraged portfolios that they provide exposure to. Instead, they “borrow“ assets from a counterparty, usually a big bank or investment firm. There’s a risk that these ETFs will not provide the expected return if the counterparty goes bankrupt.
As with any leveraged investment, your potential gains are multiplied – but so are your losses if the index moves the other way. You can never lose more than the amount of your original investment, but you can lose all of it.
Content in this section is provided in partnership with Investor Education Fund, a non-profit organization founded and supported by the Ontario Securities Commission that provides unbiased and independent financial tools to help Canadians make better money decisions. To find out more, go to: GetSmarterAboutMoney.ca
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