E. Leveraged ETFs

Why invest in Leveraged ETFs?

Overview

Leveraged ETF’s are constructed to magnify your exposure to the underlying benchmark by a factor of 2x or 3x. For example for each $1 that is invested in a leveraged ETF, you will have a $2 or $3 exposure to the underlying index. This is done through positions in derivatives such as futures and swaps. The exposure can be either a leveraged long (regular ETF) or a leveraged short (inverse ETF).

Challenges

Returns on the leveraged ETF may not exactly track the leveraged returns (e.g. 2:1) of the underlying index because of ‘compounding risk’ resulting from the daily re-balancing of the position. This means that the original trade is closed on a daily basis and re-instated at the opening level the next day. Hence, leveraged ETF’s are better suited for short-term (same day ?)  investment objectives.

Performance

Comparing $100 invested in S&P500 (SPY) vs 2x inverse exposure of S&P 500 (SDS) vs 2x exposure of S&P 500 (SSO) reveals the following performance (Oct14-Sep15). The cumulative returns are 0.32%, -11.26% and 0.51% respectively – which are not necessarily in the ratios ( x2) of the exposure constructs.

 

 

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