This Lesson describes the investment objective, composition, and exposure levels of a daily 3x leveraged ETF.
Now let’s explain the goals and implications of leveraged ETFs using Jack and Jill. Two investors with very different investment objectives and levels of experience in the investment world. Jack is a conservative investor. He’s generally knowledgeable about the markets and has built a portfolio of investments intended to help him save for his retirement. He has a buy-andhold approach to investing and does not want to take on a lot of risk in his portfolio or monitor his investments every day. Jack is more focused on the long-term and thinks in terms of years when planning his investments.
Jill on the other hand is a much more aggressive investor. In fact, she’s really more of an active trader than she is an investor. She has years of investing experience and is regularly trying to take advantage of short-term opportunities that the markets present in order to try and improve the return on her investments. Jill thinks in terms of days and weeks when planning her investment strategy. Jill knows a lot about ETFs and is willing to take on potentially high levels of risk to achieve her goals from day-to-day.
Since Jack is a buy-and-hold investor he decides to purchase a U.S. large cap ETF as part of his retirement portfolio. This ETF is composed of securities, stocks, meant to replicate a U.S. large cap index’s performance. He invests $100 and sees that over the following year the index rises by 5%, which means that his ETF also rises by 5%. Jack is pleased that his initial investment of $100 is now worth $105 and may review his overall allocations to see whether it is time to rebalance. Jack is not the type of investor that would want to consider a leveraged ETF.
Jill’s in-depth research has given her reason to believe that the market today will swing upward. Because she is more willing to take on additional risk, Jill decides she wants to augment her exposure to the market by using a leveraged ETF. Jill understands that leveraged ETFs are distinguished by two key features. They have built-in leverage and seek daily investment results. While an ETF like Jack’s is composed entirely of stocks to replicate an index’s gains or losses a leveraged ETF like Jill’s will also use derivatives, usually futures or Total Return swaps in order to obtain the requisite exposure level of two or three times that of a non-leveraged ETF.
For example, say Jill purchases $100 of shares in a daily 3x leveraged bull ETF because she believes the index is going to move upwards during the course of the day. The ETF she buys has magnification of three times which provides 300% exposure to the market or a three-to-one ratio on the market’s daily gains or losses. For Jill that means that her total exposure to the index for the day is $300.
Just as Jill thought the market goes up and the index rises 1% during the day. Her leveraged ETF returns 300% of that rise or 3%. At the end of the day, Jill’s $100 initial purchase is now worth $103 dollars. However, if Jill had been wrong and the index had gone down by 1% during the course of the day, she would have lost 3% or three times the index’s losses. Her initial $100 purchase of shares would then be worth just $97.
This is why investing in leveraged ETFs is risky. Leverage can be a powerful investment tool to enhance returns, but it also increases investment risk in a portfolio.
So much for leverage, what about daily returns? Jack’s investment into an ETF was made with the intention of being able to hold on to it for longer periods of time. Purchasing an ETF that seeks only to replicate the index decreases the amount of monitoring he might have to do on his portfolio.
However, when Jill buys her leveraged ETF in the morning, she knows that the fund’s objective is to deliver a 300% return on the index’s performance only for that day. She knows that leveraged ETFs only seek to provide daily returns on their benchmarks.
If Jill holds the ETF for longer than a day, its performance could be significantly higher or lower than 300 percent of the index performance for that holding period because of how rebalancing and compounding can affect leveraged ETF returns.
If you want to trade leveraged ETFs like Jill, you should know about rebalancing and compounding which we’ll cover in greater detail in our next video segment.
As a sophisticated investor Jill has familiarized herself with all of Direxion’s share offerings, which are divided into two main categories: Bull funds and bear funds. As the two names suggests, bull funds and bear funds allow investors like Jill to take advantage of bull or bear market conditions. For example, if the market were trending downward Jill might instead choose to obtain inverse exposure through a 3x bear ETF, an inverse fund that is designed to seek three times the inverse or negative 300 percent of the performance of the index, which means Jill has $300 dollars’ worth of inverse exposure. If the index drops by 1%, this ETF is designed to rise by about 3%. If the index rises 1%, it would drop by about 3%.
Our recommendation for prospective investors is to seek the advice of an investment professional before investing in Direxion shares or any other leveraged ETFs. To learn more about Direxion’s leveraged ETFs please visit www.DirexionInvestments.com.
Disclosure: Interactive Brokers
Information posted on IBKR Traders’ Academy that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Academy are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.
This material is from Direxion and is being posted with permission from Direxion. The views expressed in this material are solely those of the author and/or Direxion and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
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Disclosure: Leverage ETFs
Complex or Leveraged Exchange-Traded Products are complicated instruments that should only be used by sophisticated investors who fully understand the terms, investment strategy, and risks associated with the products. Learn more about the risks here: https://gdcdyn.interactivebrokers.com/Universal/servlet/Registration_v2.formSampleView?formdb=4155