How Leveraged ETFs achieve amplified returns?

Leveraged ETFs achieve amplified returns by using financial derivatives to create multiple exposures to an index’s daily performance. Unlike traditional ETFs, which aim to mirror an index’s return, leveraged ETFs target a multiple of the daily return, often 2x or 3x, and sometimes offer inverse exposure as well, such as -2x or -3x. Here’s how they achieve this leveraging effect and some examples to illustrate it:

1. Using Financial Derivatives to Achieve Leverage

Leveraged ETFs rely heavily on derivatives like swaps, futures, and options to amplify returns. These instruments allow the ETF to control a much larger position in the underlying asset than the actual cash holdings in the fund.

Swaps: A swap is a contract between two parties to exchange cash flows. In a leveraged ETF, the fund manager might enter into a swap agreement with a financial institution to gain exposure to 2x or 3x the daily returns of an index. This swap agreement allows the ETF to “borrow” the additional exposure needed to achieve the desired leverage without having to directly hold the underlying assets.
Futures Contracts: Futures are agreements to buy or sell an asset at a predetermined price in the future. Leveraged ETFs often use futures contracts to maintain exposure to the index they aim to track. For instance, a 3x leveraged ETF for the NASDAQ-100 might hold futures contracts on the NASDAQ-100 index, aiming to triple the index’s daily movements.
Options: Options provide the right, but not the obligation, to buy or sell an asset at a specific price within a certain time. Leveraged ETFs may use options to manage risk and exposure, although options tend to be used less than swaps and futures due to their added complexity and premium costs.

These derivatives allow leveraged ETFs to control a position much larger than the fund’s cash holdings, providing the amplified exposure (such as 2x or 3x) that investors seek. Importantly, these instruments also allow leveraged ETFs to rebalance daily, which is essential to maintaining the fund’s leverage target.

2. Daily Rebalancing to Maintain Leverage

To meet their target multiple (such as 2x or 3x) daily, leveraged ETFs rebalance at the end of each trading day. This rebalancing involves adjusting the fund’s holdings of derivatives to match the desired leverage based on the closing price of the underlying index.

How Rebalancing Works: Suppose an index gains 2% in a day. A 2x leveraged ETF aiming to double the daily return would need to adjust its holdings to reflect a 4% gain for that day. Conversely, if the index loses 2%, the leveraged ETF needs to adjust to reflect a 4% loss. This rebalancing is essential for the ETF to keep its 2x or 3x multiple for the next trading day, regardless of what happened previously.
Example of Rebalancing with the S&P 500:
- Let’s assume an investor holds a 2x leveraged ETF for the S&P 500. If the S&P 500 rises by 1% on a given day, the ETF will aim to increase by 2% for that day. The fund will then rebalance by adjusting its holdings so that the following day, it can target 2x the S&P 500’s return again, starting from its new base value.
- If on Day 2, the S&P 500 falls by 1%, the 2x leveraged ETF will fall by about 2% from its rebalanced starting value on Day 2. This process of resetting each day is why leveraged ETFs track their multiple on a daily basis, not over longer periods.

3. Impact of Compounding on Returns

Because leveraged ETFs reset daily, the effects of compounding can create significant discrepancies in returns over periods longer than a single day. This means the cumulative return of a leveraged ETF over weeks or months can diverge from what one would expect by simply applying the leverage multiple to the underlying index’s cumulative return.

Example of Compounding:
- Let’s assume a 2x leveraged ETF on an index. Suppose the index gains 5% on Day 1. The ETF would aim for a 10% gain. However, if the index then falls 4.76% on Day 2, bringing it back close to its initial value, the leveraged ETF will experience a 9.52% loss on Day 2 (2x the index’s loss). Despite the index returning to nearly its starting point, the leveraged ETF ends with a small net loss due to the compounding effect of the daily returns.
- Over time, this effect becomes more pronounced, especially in volatile or sideways markets. For this reason, the returns of a leveraged ETF held over an extended period might not match the expected multiple of the index’s performance over that period.

4. Example of Leveraged ETFs in Practice

Let’s look at a popular leveraged ETF, ProShares UltraPro QQQ (TQQQ), which is a 3x leveraged ETF tracking the NASDAQ-100:

Daily Objective: TQQQ seeks to provide 3x the daily performance of the NASDAQ-100 index. If the NASDAQ-100 goes up by 1% in a day, TQQQ would aim to go up by approximately 3%. Conversely, if the NASDAQ-100 falls by 1%, TQQQ would aim to drop by about 3%.
Performance Over Time: Over a single day, TQQQ’s returns align closely with 3x the NASDAQ-100. However, over longer periods, especially in choppy markets, TQQQ’s cumulative return can diverge significantly due to the daily resetting and compounding effect. This is why long-term investors need to be cautious with leveraged ETFs; their performance over extended periods can be unpredictable.

5. Who Should Consider Leveraged ETFs?

Leveraged ETFs are generally more suitable for:

Short-term Traders: Day traders and swing traders who monitor markets daily and capitalize on short-term trends.
Experienced Investors: Those familiar with derivatives and the risks of leverage.
Speculators and Hedgers: Investors who use leveraged ETFs to bet on short-term movements or hedge other positions.

In summary, the logic of leveraged ETFs is based on providing short-term amplified exposure to an index’s daily movement through derivatives and daily rebalancing. While they offer opportunities for significant gains over short periods, the daily resetting and compounding effect make them challenging for longer-term holds. Understanding these dynamics can help investors better assess when and how to use leveraged ETFs within their strategies.