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There currently seems to be a lot of investor demand for leveraged products around the globe. While the Securities and Exchange Commission (SEC) has declined multiple applications for ETFs with a higher leverage than 200% in the U.S., we have seen the launch of leveraged ETFs on the MSCI World Index in Europe. I won’t discuss whether it is a good idea to use a leveraged MSCI World ETF here but given the strong in- and outflows in leveraged ETFs on a global basis, it is worthwhile to explain how these products work.

Generally speaking, leveraged long or short ETFs are products which should only be used by experienced investors with a dedicated view on specific markets or market segments, as the timing for buying and selling these products is crucial for the success of the investor.

In more detail, since the basis for the calculation of the performance of leveraged ETFs is set on a daily basis, these products are made for short-term, in most cases intraday, trading and not for long-term positions as the leverage works in both directions. This means that any loss will also be leveraged.

If the underlying market of a leveraged long ETF gains 1% on a given day, the ETF will gain 2%. At the same time a short ETF on the respective index will lose 1%, while a leveraged short ETF on the same index will lose 2%, and vice versa. As long as the market moves in the right direction for the leverage, the investor will harvest respective gains. This means it is important to get the market direction right. But what happens when there is a market crash? If the market falls by 25%, an investor in a leveraged (double) long ETF will lose 50% of the capital invested since the price (net asset value—NAV—of the ETF) will go down 50%. This means that the respective ETF will start with a 50% lower NAV the next day. If the market increases by 25% on that day, the NAV of the ETF will be 75% of the amount with which the investor started. This means the investor has still lost a quarter of their capital despite the fact that the underlying market is near its value of the beginning of the first day.

Now one can say the example above is quite extreme since markets normally do not lose 25% in a single trading session. This is right, but the example does clarify what is happening to the investor’s capital when he or she catches the wrong market movement. The effect described above has even worse effects if an investor holds a leveraged product for more than one day in a market which has high volatility.

With regard to this, it can be said that leveraged products are made to participate from market trends on a short-term basis, hence these products are highly speculative and should only be used by experienced investors who are able to bear possible losses from using leveraged products. Leveraged ETFs are opposite to plain vanilla, the so-called “delta one” products which “only” replicate the performance of their underlying indices, not eligible for long-term investments. In addition, investors who are using leveraged products must ensure that they can monitor the results of these products within their portfolio on an ongoing basis. Since the risk of leveraged products does increase when the leverage factor is increasing, it is clear why the SEC has rejected the applications to launch leveraged ETFs with a higher leverage than 200% which may become available to retail investors.

From my point of view, the investor demand for leveraged ETFs is a bit scary since most investors are used to making long-term investment decisions and do not have enough experience to trade leveraged ETFs on an intraday basis. To be clear, even as ETFs are made for short-term transactions and intraday trading, they are in most cases used to implement strategic long-term positions in an investor’s portfolio and not to trade intraday on the direction of an index, since this is speculation and not investing.

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