Leveraged ETFs definition
Leveraged ETFs are a form of exchange traded fund (ETF) that seek to deliver multiplied returns of the underlying benchmark they track. For instance, if the FTSE 100 increases 10% in a day, a 2x FTSE ETF will aim to increase 20%.
Most leveraged ETFs will seek to deliver two or three times the return of their benchmark. They do this by making use of financial derivatives and debt. These ETFs carry a significant degree of additional risk, and will also see much greater compounding than non-leveraged ETFs.
Compounding in leveraged ETFs
It is important to consider the effect of compounding with leveraged ETFs. While compounding applies to both non-leveraged and leveraged ETFs, it is magnified with leverage. As such, compounding in leveraged ETFs can result in significantly greater or lower returns than you may expect.
Say, for example, that the FTSE increases 10% in a single day. A 2x FTSE 100 ETF would rise in value by 20%. But if the FTSE rises 10% one day and then falls by 9.09% the next day, a 2x FTSE 100 ETF will have made a loss.
This is because of compounding. If the 2x FTSE 100 was trading at £100 and increased in value by 10% to £120, then when the FTSE falls by 9.09% the next day the leveraged ETF will fall 18.18% and now only be worth £98.18 (120 – 18.18%).
As a consequence, you would have lost £1.82, despite the market being effectively neutral over two days.
During volatile markets, using a leveraged ETF can result in significant losses, even if at the end of the volatility the market is neutral.