Leveraged ETFs are a relatively new species of rapidly growing ETFs, that have already crossed the $6 billion dollar mark – for assets under management.
Leveraged ETFs track an index, commodity, currency or sector, and target double or triple daily returns of the index. So, a 2X Leveraged ETF that tracks oil prices will gain 10%, if oil gains by 5% in a day. By their very nature, Leveraged ETFs provide daily returns, and are rebalanced every day. That means – a 2X Leveraged ETF will return 4% in a day – if the underlying index rises 2%, but it will not return 4% over a week, if the index rose 2% over the week. For an explanation of this visit this example of daily leveraged returns from a Leveraged ETF.
How does a Leveraged ETF make money?
While the functioning of each leveraged ETF will differ from another; at a high level – Leveraged ETFs invest in a mix of short-term fixed income investments (like US Treasuries, bank deposits, money market funds, repo agreements) and derivative options.
The cash and cash equivalents (like T – Bills) provide collateral for buying derivative instruments, which are then used to create an investment vehicle that returns twice or thrice the underlying asset.
The most common instruments that Leveraged ETFs invest in are:
1. Swap Agreements: A swap agreement is an agreement between two institutional parties that exchange returns for a particular period of time based on an underlying asset. For example, in an – Interest Rate Swap – two parties will agree upon a notional amount, one party will pay the other a fixed rate of interest, while receiving a – floating rate – pegged on something like LIBOR.
2. Forward Contracts: A – Forward Contract – is a contract between two parties – to carry out a transaction on an asset at a future date on a predetermined price.
3. Future Contracts: Futures are like Forwards, but the difference is that Futures are traded on a stock exchange and can be bought or sold at any given time. As opposed to Forwards whichÂ can be executed only at a certain future date.
4. Options: Call and Put Options of the underlying asset are traded by Leveraged ETFs, in their regular dealing.
At any point in time, a Leveraged ETF holds a combination of these instruments, such that, they return twice or thrice the underlying asset in a day (based on the fund type).
Apart from the Options – the Beta of the other contracts has to be 1 or close to 1, so that the fund moves in tandem with the underlying asset. The Leveraged ETF constructs this combination of instruments every day, and trades it daily in order to be perfectly aligned with the goal of returning twice or thrice the index.