Leveraging The Market With An ETF

The addition of the word “leverage” to any term is indication of added risk. Investing in a leveraged exchange traded fund can provide access to the portfolio of an index, but with magnified degrees of  risk and return.

Exchange traded funds track an index. Leveraged ETFs track an index, but with exaggerated results through the use of debt.

Photo by Anyaka, cortesy of flickr

Leveraged ETFs use debt in order to invest. The use of debt comes at a cost, so the goal of a leveraged ETF is to provide returns greater than the cost of borrowed funds.

A leveraged ETF that tracks the S&P 500 may use $1 debt for every $1 of capital invested. This gives the fund’s investors $2 of exposure to the S&P 500 portfolio.

Today, the S&P 500 returned 2.16 percent. A leveraged ETF tracking the S&P 500 should have returned 4.32 percent.

If the S&P 500 lost 2.16 percent, then the leveraged ETF tracking it should have lost 4.32 percent.

In this example, the ETF used a ratio of 2:1. Depending on the S&P 500’s daily happenings, the portfolio of the ETF will have to be adjusted through a process called rebalancing.

The fund’s managers use derivatives to stay as close to the fund’s ratio as possible. The rebalancing process can become complicated so sometimes the ratio may be close, but not exact.

A few things to consider before investing in a leveraged ETF:

In addition to interest on borrowed funds, there are transactions costs and management fees. The management fees can run up to 1 percent of the fund’s assets.

When the markets are good a leveraged ETF can provide extra rewards, but remember risk goes both ways!

For a list of leveraged ETFs, visit Stock-Encyclopedia.com.