Leveraged ETFs - Fidelity (2024)

Leveraged ETFs have received tremendous media attention and are proving to be extremely popular with both individual and institutional investors. There are hundreds of leveraged ETFs, covering virtually every asset class and industry sector. The majority are double-leveraged, but there's a sizeable group of triple-leveraged ETFs.

For professional investors, leveraged ETFs are useful in statistical arbitrage, short-term tactical strategies, and for use as short-term hedges without the need to roll futures. For individual investors, leveraged ETFs are alluring because of the potential for higher returns.

What does leverage mean?

Uninformed investors might assume that the leverage returns are generated on a continuous basis, so that if an underlying index is up 5% for a month, the double-leveraged ETF will be up 10% for the same month; if the index is up 10% for 6 months, the ETF will be up 20%, and so forth. That is absolutely not the case. The leverage is determined on a daily basis and the returns for any other period usually will not be double or triple the underlying index.

In order for the leveraged funds to achieve appropriate levels of assets so they can provide their implied leverage, they have to rebalance daily. In the case of an ETF providing long 2-times leveraged exposure, they would typically attain exposure to a notional set of assets equal to 2 times their NAV. An example would be an ETF that takes in 100 units in assets that does a swap with a counterparty to provide exposure to 200 units in performing assets. The rebalancing activity of these funds will almost always be in the same direction as the market.

In essence, a leveraged ETF is essentially marked to market every night. It starts with a clean slate the next day, almost as if the previous day had not existed. This process produces daily leverage results. However, over time, the compounding of this reset can potentially vary the performance of the fund versus its underlying benchmark. This can result in either greater or lesser degrees of final leverage over individual holding periods.

Performance

Generally speaking, daily compounding of leveraged long ETFs can result in increasing percentage gains in rising markets and decreasing percentage drops as markets trend lower. If an index rises for several days in a row, the trending movement is very important, as that will translate into ETF growth at a faster pace as the value of the index is increasing. For a long leveraged product, it will outperform its expected goals in a rising market and will underperform its expected goals in a falling market.

In the chart directly below, we see what happens to the value of a double-leveraged ETF in a market that rises 10% each day for 10 days in a row. The index and the double-leveraged ETF tracking that index both started out at 100. As the market rose 10% on day 1, the index also rose 10% to 110, and the ETF rose 2 times 10% to 120. In essence, the ETF is doing what it is supposed to do: produce results that equal 2 times the daily performance of the index. However, because of an increasing price, those gains are driving the value higher at a faster pace. What this shows is that in a trending market—because of daily compounding—you achieved a return of much greater than twice the index return.

Rising market data grid—market up 10% daily for 10 days

Falling market data grid—market down 10% daily for 10 days

Flat and volatile grid—market up 10% and then down 10% for 10 days