The Pros and Cons of Leveraged ETFs Every Investor Must Know

By: Olivia Warner Last updated: 08/08/2024

Exchange-traded funds (ETFs) have become a popular investment choice for both beginners and experienced investors. They offer diversification, convenience, and cost-effectiveness. However, not all ETFs are created equal. Leveraged ETFs are a specialized type of ETF that can amplify gains—but also magnify losses. These financial instruments are designed for short-term trading and can be risky for those who don’t fully understand how they work.

For beginners in investing, leveraged ETFs can seem like an exciting opportunity to increase returns quickly. However, they also come with significant risks that every investor should consider before jumping in. Are leveraged ETFs a smart addition to your portfolio, or do they pose too much danger for your financial goals?

In this guide, we’ll break down what leveraged ETFs are, how they work, and their potential advantages and disadvantages. By the end, you’ll have a clearer understanding of whether leveraged ETFs align with your investment strategy.

What Are Leveraged ETFs?

A leveraged ETF is a type of exchange-traded fund that aims to amplify the daily returns of a specific index, sector, or asset class. These funds use financial derivatives and debt to increase exposure, meaning that they don’t just track an index—they multiply its gains or losses.

For example, a 2x leveraged ETF is designed to return twice the performance of an underlying index for a single day. If the index increases by 1%, the leveraged ETF should theoretically increase by 2%. A 3x leveraged ETF would aim for three times the return. However, this also means that if the index drops by 1%, a 2x leveraged ETF would lose 2%, and a 3x leveraged ETF would lose 3%.

How Do Leveraged ETFs Work?

Leveraged ETFs achieve their amplified returns through:

Derivatives – These include options, futures contracts, and swaps that help boost returns.
Borrowed Money (Leverage) – The fund takes on debt to increase investment exposure beyond the actual cash available.
Daily Resetting – Most leveraged ETFs reset daily, meaning their performance is calculated only on a day-to-day basis rather than over the long term.

This daily reset feature is a key factor that makes leveraged ETFs very different from regular ETFs and more suitable for short-term traders rather than long-term investors.

Pros

While leveraged ETFs can be risky, they do offer some advantages for certain types of investors.

1. Potential for Higher Returns

The main appeal of leveraged ETFs is the ability to amplify gains. If the market is moving in your favor, a leveraged ETF can generate returns two or three times greater than a traditional ETF tracking the same index. This can be attractive to active traders looking to capitalize on short-term price movements.

For example, if the S&P 500 rises by 2% in a day, a 2x leveraged S&P 500 ETF could theoretically return 4%, allowing traders to profit more quickly than with a standard ETF.

2. Easy Access to Leverage

Investors who want to amplify their returns typically need to borrow money on margin, which requires approval from a brokerage and comes with risks like margin calls. Leveraged ETFs provide built-in leverage, making it easier for investors to access increased exposure without needing a margin account.

3. Short-Term Trading Opportunities

Because leveraged ETFs reset daily, they are most effective for short-term trading. Traders who closely monitor market trends can use leveraged ETFs to take advantage of daily price swings and potentially earn quick profits.

For example, a trader who expects a strong market rally over the next few days might use a 3x leveraged ETF to maximize gains during that short window.

4. Liquidity and Convenience

Leveraged ETFs are traded on major stock exchanges like the NYSE and NASDAQ, making them easy to buy and sell throughout the trading day. This makes them more accessible than some other leveraged trading strategies, such as futures or options, which can be more complex and require additional margin requirements.

Cons

Despite their advantages, leveraged ETFs come with significant risks that investors must carefully consider.

1. Increased Risk and Volatility

While leveraged ETFs can amplify gains, they also magnify losses. If the market moves against you, losses can accumulate much faster than with regular ETFs.

For example, if an investor buys a 3x leveraged ETF and the underlying index drops 5%, the ETF could lose 15% of its value in a single day. This makes leveraged ETFs a high-risk investment, especially for inexperienced investors.

2. Compounding and Daily Reset Risks

Because leveraged ETFs reset daily, their long-term performance can deviate significantly from what investors expect. Due to compounding effects, the actual returns over weeks or months may not match the simple multiple of an index’s return.

For example, suppose the S&P 500 moves up 5% one day and down 5% the next. A traditional ETF would be roughly flat, but a 2x leveraged ETF could be down due to how daily resets affect returns over time.

3. Not Suitable for Long-Term Holding

Unlike traditional ETFs, which are designed for long-term investing, leveraged ETFs are meant for short-term trades. Holding them for extended periods—especially during volatile markets—can result in unexpected losses due to daily compounding effects.

Many investors mistakenly assume that if the market rises 10% over a year, a 2x leveraged ETF would rise 20%. However, due to the daily resets and market fluctuations, the actual return could be much lower or even negative.

4. Higher Expense Ratios

Leveraged ETFs have higher management fees compared to traditional ETFs. These fees cover the costs of managing the fund’s leverage and derivatives. While most ETFs have low expense ratios (often below 0.5%), leveraged ETFs can have expense ratios of 1% or higher. Over time, these costs can eat into potential profits.

5. Greater Market Timing Challenges

Since leveraged ETFs are highly volatile, they require active monitoring and market timing. Investors who don’t have the time or expertise to track short-term price movements may find it difficult to use these funds effectively.

If you’re not comfortable with actively managing your portfolio or making quick trading decisions, leveraged ETFs might not be the best fit for your investment strategy.

Leveraged ETFs can be a powerful tool for traders who understand the risks and use them for short-term trading. However, they are not ideal for long-term investors or those who prefer a hands-off investment approach.