The Securities and Exchange Commission gave the green light to leveraged ETFs in 2006. In a nutshell, these funds are typically based on an underlying index such as the S&P 500 or a commodity spot price for, say, natural gas. Most leveraged ETFs maintain a $2 exposure to the index for every $1 of investor capital—in what’s known as “2x” funds. As mentioned before, there are also a range of “3x” funds.
The top five largest leveraged ETFs account for more than $11 billion in assets.
Despite its size, the category is not for the faint of heart. That’s because leverage works the opposite way as well, magnifying losses at a rate that can rattle even the calmest and most farsighted investor.
Unsuitable For Most?
To be clear, leveraged ETFs aren’t held in high esteem by many investors. In early January, Vanguard went so far as to stop accepting trade orders in leveraged or inverse mutual funds, ETFs or exchange-traded notes. Vanguard’s rationale is that these products are very speculative and highly complex and typically don’t fit with a traditional buy-and-hold strategy.
Joe Mallen, chief investment officer at Helios Quantitative Research, doesn’t disagree with Vanguard that leveraged ETFs are not designed as long-term vehicles. “They’re a tool, not an investment,” he says, adding that they’re very misunderstood by most people who use them.
Mallen says leveraged ETFs are “very good for short-term directional bets.”
The same can be said for options, but Mallen argues that it can be a challenge to find sufficiently liquid options contracts to match a short-term target. And if you choose a less-liquid contract that doesn’t have a lot of trading volume behind it, “you’re paying up for wide trading spreads on the way in and the way out.” With leveraged ETFs, in contrast, “the round-trip trading costs could be cheaper,” he says.
Nonetheless, leveraged ETFs aren’t a great bargain when it comes to costs. The ProShares leveraged ETFs, for example, typically carry expense ratios in the range of 0.90% to 0.95%.
Leveraged and inverse products offered by Direxion, the other big player in this space, typically charge expense ratios in the neighborhood of 1.0%. These funds let investors speculate on almost any corner of the market, such as robotics, home builders, gold miners and many more. And investors can glean leveraged exposure to various countries such as Russia, India, Japan and South Korea.