When you’re dealing with financial instruments, making sure your terms are correct is essential! You must have the proper information in order to make informed decisions; in anything; but in investing this is very important. The difference between some financial instruments may seem insignificant but the difference can be huge and can really be the difference between you making and losing money. So it goes for the financial instrument known as the “leveraged ETF.”
What is an ETF:Before we get to the meat and potatoes of just what a leveraged ETF is we first need to be working with the same definitions. According to Investopedia.com an ETF is an acronym for “exchange traded fund.” An ETF works to keep in lock step with the indexes (NASDAQ, Dow Jones, S&P500) and its value fluctuates throughout the trading day as it is bought and sold. The benefit of an ETF is investors get “the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share.” Buying and selling ETF’s is much the same as buying and selling stock, however the maintenance fees for ETF’s is generally far lower than an average mutual fund.
What is a Leveraged ETF: If an ETF strives to match the returns of the indices than it would serve to reason that a leveraged ETF would end up amplifying these returns. This can be good for the investor if the indexes are on a positive upward trend and devastating for investors if the returns are depressed. For example, a leveraged fund with a 2:1 ratio means that “each dollar of investor capital used is matched with an additional dollar of invested debt. If one day the underlying index returns 1%, the fund will theoretically return 2%
The Problem with Leveraged ETF’s: The big issue with some investors on leveraged ETF’s is for every penny lost in the indices there are that many more lost from your ETF. If your leveraged ETF is on a 3:1 ratio and the indexes you’re invested in have lost 1%, then your ETF would have lost 3%.
The Bottom Line with Leveraged ETF’s: Leveraged ETF’s are a good investment for those who don’t have the time to bother with the day-to-day of what goes on in individual stocks, but who would like to participate in the upside of the market swings. Leveraged ETF’s are also a good fit for the active trader who has been charting trends and sees movement in one direction or another for a broad index.