What are leveraged ETFs and are they worth the risk?

Exchange-traded funds (ETFs) are picking up in popularity in India. However, a relatively riskier type of ETF called leveraged ETFs has also gained prominence globally in recent years. In this article, we analyze what leveraged ETFs are, explore their pros and cons in the Indian context, and assess whether leveraged ETFs are worth the risk.

• Table of contents

1. What are leveraged ETFs?
2. Advantages of leveraged ETFs
3. Disadvantages of leveraged ETFs
4. How risky are leveraged ETFs?
5. Are leveraged ETFs worth the cost and risk?

What are Leveraged ETFs?

Leveraged ETFs are a type of actively managed Exchange Traded Funds (ETFs) that use financial derivatives and debt to amplify returns on the underlying benchmark. For example, a 2x leveraged ETF aims to deliver twice the daily performance of the index it tracks. They do this through strategies like borrowing money to buy more of the underlying assets.

While regular ETFs simply track an index, leveraged ETFs take it a step further by multiplying gains and losses. In India, leveraged ETFs are currently not permitted due to regulatory restrictions. However, they are widely available in international markets and provide Indian traders access to global assets.

Leveraged ETFs track popular indexes like Nifty50, Bank Nifty, NASDAQ, or S&P500 with leverage factors of 2x, 3x, or other multiples. For example, an investor can buy a 3x leveraged Nifty ETF to potentially gain three times the daily Nifty returns.

Read Also: ETF vs. Index fund - Understanding the difference

Advantages of Leveraged ETFs

• Returns: Leveraged ETFs allow traders to amplify profits when markets are trending upwards. Gains can be substantially higher than regular ETFs.
• Leverage without Margin: Leveraged positions can be created without borrowing on margin and facing margin calls.
• Low Cost: Despite active management, leveraged ETF expenses are typically lower than other leveraged investment options.

Disadvantages of Leveraged ETFs

• High Risk of Loss: During falling markets, leveraged ETF losses are also amplified. Even a small downturn can wipe out all profits quickly.
• Daily Index Tracking: They track the underlying index's daily, not long term, performance. Gains/losses are compounded daily.
• Volatility Drag: Over longer periods, volatility kills returns as the effects of daily leverage compound.
• Complex Derivatives: The complex strategies employed involve derivative risks that may not be understood fully by investors.
• High Portfolio Allocation Needed: To achieve meaningful profits, large allocations are needed which increases risk proportionately.

How Risky are Leveraged ETFs?

The risks with leveraged ETFs are significantly higher compared to regular ETFs or mutual funds due to leverage. Since they aim to multiply returns on a daily basis, even small market fluctuations can translate into large profits or losses, since leverage effectively magnifies both upside and downside. For example, a 2x Bullish ETF tracking Nifty50 that loses 10% in a day will lose investors 20%.

Also, leveraged ETFs do not track long term returns but only seek to deliver leveraged exposure to daily price moves. Over time, volatility and daily compounding impacts can erode gains substantially. As many traders do not hold positions for more than a week, these effects are less concerning. But for longer-term investment horizons, volatility drag poses a serious risk.

Read Also: What are the benefits of investing in an ETF

Are leveraged ETFs worth the cost and risk?

Given the highly leveraged nature and riskiness of these products, it is debatable if leveraged ETFs are suitable for retail investors in India.

Some points to consider:

• High volatility makes them extremely risky for long term goals like retirement.
• Losses may far exceed premium returns during drawdowns.
• Returns may underperform the underlying index over time due to volatility drag and costs. Leveraged short term trading requires market timing ability and skills to exit positions at the right time. Losses can mount quickly otherwise.
• Large portfolio allocations may be needed to gain material profits, but equally large losses are possible if markets move adversely.
• Regulatory restrictions do not allow direct investment, but traders must assume currency and overseas market linkage risks.
• For experienced traders with a higher risk appetite, ability to actively monitor positions, and make large speculative bets, leveraged ETFs may offer profit-making chances. Tools like a Compound Interest Calculator can help evaluate long-term investment strategies by simulating different interest rates, time periods, and compounding frequencies to assess potential future returns.

Conclusion

While leveraged ETFs offer gain potential by amplifying returns, risks are also magnified enormously. Daily compounding of gains and losses interacts unfavorably over longer periods. Given the relatively high costs, complexity, and risks – leveraged ETFs are avoided by Indian retail investors for long term goals. However, experienced traders may opt to add small speculative positions as part of a well-diversified portfolio. Overall, it is debatable if leveraged returns compensate for amplified downside risks in the Indian context currently. Investors can use an SIP mutual fund calculator to plan their investments wisely, taking into account their risk tolerance and investment horizon. A lumpsum mutual fund calculator can similarly help those planning a one-time investment in a mutual fund or an ETF.

FAQ:

How long can leveraged ETFs be held?

It is generally not advised to hold leveraged ETFs for more than a day or a week at most due to volatility drag. Daily gains/losses are leveraged but get offset over longer periods due to volatility.

How can Indians invest in global leveraged ETFs?

Indian traders can invest through brokers offering trading in international markets. Funds have to be transferred overseas and positions held through foreign currency trading accounts incurring additional costs and risks. Direct investment in Indian markets is not permitted for now.

Mutual Fund investments are subject to market risks; read all scheme-related documents carefully.
This document should not be treated as an endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals, and horizon. This information is subject to change without any prior notice.