Leveraged ETF Lesson

Sometimes, after highlighting a futures market trade opportunity, I get an email from a reader asking if they can put that trade on using leveraged ETFs.  My answer is always the same - leveraged ETFs are fine for short-term trading, but you never want to hold them for a long period of time!

Leveraged ETFs often get a bad rap. They shouldn't. They do what they were designed to do remarkably well. The real confusion lies in investors' understanding of how the leverage is achieved.

Let's go through an example of a typical margin or futures account trade to understand how "traditional" leverage is accomplished and then compare it to the methodology used in a leveraged ETF.

For a "traditional" leveraged trade, an investor buys a security at a price of $100 and puts up $35 of margin with the broker lending the balance of $65.  We will use a 35% margin rate for this example, but that can differ depending on the instrument.  The investor must maintain an "equity" value of 35% the value of the security at all times.  If the security rises in value, the investor can actually withdraw the extra amount.  However, if the security's price falls, the investor must meet the margin call or the position will be liquidated.  Pretty simple.

On the other hand, let's examine a leveraged ETF.  For this example, we will use a three times ETF in which the underlying assets of ETF trust are $100 million.  The ETF administrator must then borrow $200 million in some fashion to allow the investor to achieve a 3 times return.  So far, it's similar to the "traditional" margin buying in the previous example.  But what happens if the price of the asset falls?  If all of a sudden the $300 million portfolio loses $60 million, there would only be $40 million of equity versus $240 million of assets.  The ETF cannot issue a "margin call" on its holders, so have to find some way to protect themselves.

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Disclosure: None.

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