Dave draws off his years of experience as a Financial Advisor and Analyst to teach others all about finance and the investing world.
The Double-Edged Sword of Leverage
Among the most controversial new products in the investment landscape are leveraged ETFs. Meant to be short-term trading vehicles, these are one of the most misunderstood products available. In this lesson, we'll explore what leveraged ETFs are along with some of the risks and opportunities made available through their use.
Traditional ETFs, or exchange-traded funds, are a basket of stocks sold as a unit which try to emulate an underlying market index. The most popular ETFs are constructed to mirror the performance of major market indexes like the S&P 500 or the NASDAQ 100. The underlying holdings in the ETF are put together so that the ETF moves in the same direction and by nearly the same amount as the index the ETF is trying to emulate.
The underlying holdings of an ETF are the individual securities that make up the ETF. Rather than going out and buying all the individual stocks which make up the ETF, an investor can purchase the ETF on an exchange just like a stock. They would own a basket of stocks just by making a single transaction.
For example, the NASDAQ 100 ETF would be a basket of the 100 stocks which make up the NASDAQ 100 Index. Since the holdings in the ETF are identical to the index the ETF is tracking, the daily performance of the ETF should mirror the index it's following. So, the NASDAQ 100 ETF should have about the same daily performance of the NASDAQ 100 Index. The underlying index is the index an ETF is tracking the performance of or mirroring. Here, the underlying index would be the NASDAQ 100.
Leveraged ETFs take this one step further. Rather than have a basket of stocks that attempt to mirror the performance of an index, leveraged ETFs use derivatives in order to multiply the daily return of the underlying index they're tracking. Leveraged ETFs will buy futures contracts to gain two-times or three-times the daily move of the underlying index. It is this use of derivatives which adds risks to leveraged ETFs that are not present in more traditional ETFs (which just hold individual stocks). Just like traditional ETFs, leveraged ETFs can be bought and sold on the stock exchange each day. You can trade leveraged ETFs like traditional ETFs or any stock.
Decay, Risk, and Volatility
One major factor seen in leveraged ETFs is decay. This decay is a function of the math behind having a multiplier. Let's use the example of two ETFs. The first, ABC, is an ETF that tracks the Big Index. The second, XYZ, is a leveraged ETF that returns two times the Big Index. Both the ABC and XYZ ETFs start off trading at $10 per share. Day 1, the Big Index is up 25%. The next day, the Big Index drops 20%.
After the first day, ABC rallies from $10 to $12.50, up 25% in-step with the Big Index, while XYZ goes from $10 to $15. The second day, ABC shares give back 20% or $2.50 to close back at $10. XYZ, on the other hand, gives up twice the 20% of the Big Index, 40% or $6 to close the day at $9. Even though the Big Index and ABC ETFs are both breakeven from where they started, the leveraged ETF XYZ is down $1, trading below where it started two days before. In terms of leveraged ETFs, decay is the loss of performance attributed to the multiplying effect on returns of the underlying index of the leveraged ETFs. In the example, the decay took $1 or 10% off the performance of the leveraged ETF.
This decay is compounded with the volatility of returns. Volatility is the variance of returns. Put another way, the more up and down a stock is the greater the volatility of that stock. With leveraged ETFs, since decay can eat away at profits, volatility is a huge negative factor on leveraged ETF returns. The good news is, as long as the underlying index moves in a singular direction, the effect of decay is minimal. Once there are negative days thrown in the mix, decay rears its ugly head as in the example.
Since leveraged ETFs move as a multiple of the underlying index, there is additional risk you don't see with the underlying index. While larger indexes like the S&P 500 typically move in a smaller range than individual stocks do, smaller indexes can have wild swings. There are leveraged ETFs which track high-beta sectors of the market. High-beta stocks are more volatile than the broad market. Leveraged ETFs which track these high-beta sectors can swing 20% or more in either direction on any given day.
This leverage can cut both ways. While leverage is fantastic when a trade is moving in your desired direction, it can be devastating when it works against you.
All right, let's briefly review the key concepts we covered in this lesson, starting with the concepts we covered regarding exchange-traded funds, we learned that:
- Exchange-traded funds (ETFs) are a basket of stocks sold as a unit which try to emulate an underlying market index.
- Leveraged ETFs use derivatives in order to multiply the daily return of the underlying index they are tracking.
- Underlying holdings of an ETF are the individual securities that make up an ETF.
- And finally, the underlying index is the index an ETF is tracking the performance of or mirroring.
Then we learned about decay, volatility, and high-beta stocks, as well as the risks involved.
- Decay is the loss of performance attributed to the multiplying effect on returns of the underlying index of the leveraged ETFs.
- Volatility is the variance of returns.
- And finally, high-beta stocks are more volatile than the broad market.
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