What Is A Leveraged ETF And How Does It Work?

During the year 2023, the S&P 500 index, long considered a yardstick for overall stock market performance, increased in value by an impressive 24%. If you're interested in investing in the S&P for yourself, there's an abundance of exchange-traded funds that mirror the performance of that benchmark index. Though Money Digest isn't doling out specific investment advice, some popular players to research in that space include the ticker symbols SPY, VOO, and IVV.

However, what if it was possible to amplify your gains by double or even triple the daily price movement of an underlying index like the S&P 500? Those financial products do exist in the form of leveraged ETFs. Traditional index funds operate by purchasing a basket of securities — which can be stocks, bonds, cryptocurrency like Bitcoin or Ether, and more — that perfectly reflects the composition of a particular index. However, leveraged exchange-traded funds add a combination of derivatives and debt into the mix to deliver their (sometimes) supercharged performance.

Last year, the title of best-performing leveraged ETF went to GraniteShares 1.5x Long COIN Daily ETF (CONL), which is correlated to the daily changes of Coinbase stock (COIN). Its performance for the 12 months ending January 4, 2024, was a searing 464% gain. Recently, CONL's leverage increased from 1.5x to 2x the daily movements in COIN stock. If that 464% return sounds too good to be true, there is one important caveat: leveraged ETFs also amplify losses just as quickly as they do gains. 

To begin the decision process as to whether leveraged ETFs are right for you, let's take a look under the hood at how they achieve their magic. A common tactic is for leveraged index funds to make use of options or futures contracts to increase their exposure to the basket of securities or currency that make up a particular index (which is rebalanced periodically).

Investing in options could easily be the topic of its own dedicated article, but briefly, options contracts — the option to buy or sell something at a set price in the future — allow investors to control a large block of an asset at a much lower cost than buying the asset itself. Investors who believe that the price of an asset will rise typically purchase call options, while those betting on a drop in price buy put options, though other more complicated strategies also exist.

The catch is that options have an expiration date, which can range from mere weeks to months or even years after the date of purchase. If the anticipated move in price of the underlying asset doesn't happen within the option's specified timeframe, it'll expire worthless. As well, leveraged ETFs may borrow money to supplement the money received from investors. This allows the fund to purchase twice as much (or more) securities than would be possible if using only investor funds.

The mechanics behind leveraged ETFs are difficult, but as an investor, you needn't be concerned with every last detail. Instead, consider an example where an investor purchases an ETF that promises to deliver 3x the daily price change in the aforementioned S&P 500 index. If the S&P 500 is up 1% on a particular day, the investor will receive an approximately 3% return. However, if that same index is down 1% for the day instead, the investor will lose 3%.

Leveraged ETFs are complex and as such, they're more expensive to operate than traditional funds. Frequent trading requires more active management, as well as generating more transaction fees, paying interest on borrowed money, and other expenses. Hence, the fees charged to investors are often 1% or greater.  In a nutshell, leveraged ETFs offer investors the potential for outsized gains. They can also be a surrogate for folks who want to dabble in derivatives like options without owning them directly. Leveraged ETFs are also easy to buy and sell via regular brokerage platforms, including some of the best investing apps for beginners. 

However, the negatives to leveraged ETFs include high fees, amplified risk of losing money, and the inability to track the underlying index over long periods. Therefore, moderation is key. Leveraged ETFs as a small part of a diversified investment portfolio have the potential to deliver outsized returns over a short period, provided that you're comfortable with the risk.