Leverage comes with advantages and disadvantages. It can magnify returns but it can also magnify losses, making the use of leverage a risky investment decision. There are other ways to capture leverage that do not include as much risk as the traditional methods of borrowing money. To maximize returns and increase exposure to various slices of the market, investors can consider using exchange-traded funds (ETFs) designed to return two or three times the yields of the underlying investments.
Key Takeaways
- Leverage is the use of borrowed funds in investing with the goal of magnifying returns on securities.
- The use of leverage is risky as not only do returns have the potential to be magnified but so do the losses.
- A less risky method of using leverage is investing in leveraged exchange-traded funds (ETFs).
- Leveraged ETFs act like regular ETFs in that they invest in a benchmark or sector but they utilize leverage strategies to enhance returns.
- One of the most popular investment managers offering leveraged ETFs is Direxion.
What Is Leverage?
Leverage refers to the use of borrowed funds as a means to generate higher returns on investment. Investors lever their investments through a variety of financial products, such as options, futures, and margin accounts. When an investor does not have enough capital to purchase assets on their own, they borrow to fund those purchases. The hope is that the return on investment (ROI) will be greater than the cost of borrowing.
Leverage can magnify returns but can also magnify losses and is therefore considered a risky investment strategy that should only be used by professionals. For other investors, there are less risky ways to access leverage returns, one of the best being leveraged exchange-traded funds (ETFs).
Triple the Upside/Downside on Financials
The Direxion Daily Financial Bull 3X Shares ETF (FAS) is designed to return three times the performance of the Financial Select Sector Index on a day-to-day basis. The index contains financial service providers ranging from large-capitalization banks, like Wells Fargo (WFC) and Goldman Sachs (GS), to credit card companies like Mastercard (MA) and Visa (V), as well as the giant Berkshire Hathaway (BRK.B).
The return of FAS against its benchmark index has varied over the years depending on market conditions. As of February 6, 2024, its five-year return is slightly outperforming the underlying index at 11.15% vs. 8.44%.
How Does It Work?
The FAS ETF will invest its assets in long positions of the individual securities that make up the Financial Select Sector Index. The fund also invests in financial instruments that provide leveraged and unleveraged exposure to the Financial Select Sector Index, thus, creating the ability for returns of the underlying index to be tripled.
Notice that the ETF's five-year performance is not equal to 3x the index's performance. As the prospectus notes, because of "daily rebalancing and the compounding of each day's returns over time, the return of the Fund for periods longer than a single day will be the result of each day's returns compounded over the period, which will very likely differ from the 300% of the return of the Index over the same period."
Can I Play the Downside?
The other side of the coin offers investors the opportunity to benefit from the downward slide of financials in the Direxion Daily Financial Bear 3X Shares ETF (FAZ). The FAZ fund is designed to return the inverse of the Financial Select Sector Index by creating short positions as opposed to holding long positions in equities, like its bull friendly sister, the FAS ETF.
If you are interested in exploring leveraged ETFs but are not comfortable with the 3x leverage, many ETFs offer small leverage amounts, such as 1.5x or 2x.
The five-year return for FAZ is -50.09% compared to the Financial Select Sector Index's five-year return of 8.44% as of February 1, 2024.
Other 3x Options
ETFs that offer three times the up (Bull) and three times the down (Bear) are also available as sector-specific funds. These include the Direxion Daily Technology Bull 3X Shares (TECL), the Direxion Daily Technology Bear 3X Shares (TECS), the Direxion Daily Semiconductor Bull 3X Shares (SOXL), and the Direxion Daily Semiconductor Bear 3X Shares (SOXS).
Direxion is not the only provider of leveraged ETFs but is one of the most popular. Other leveraged ETFs are offered by ProShares and MicroSectors.
What Is the Largest Leveraged ETF?
The largest leveraged ETF is the ProShares UltraPro QQQ ETF (TQQQ) with approximately $19.8 billion in assets as of February 1, 2024. It is a 3x leveraged ETF.
What Are Some of the Most Popular Leveraged ETFs?
Some of the most popular leveraged ETFs include ProShares Ultra S&P 500, ProShares UltraPro S&P 500, Direxion Daily Small Cap Bull 3X Shares, and ProShares Ultra 7-10 Year Treasury.
Can You Lose More Money Than You Invested in a Leveraged ETF?
No, you cannot lose more money than you invested in a leveraged ETF. This is one of the main reasons why leveraged ETFs are considered less risky than traditional leveraged trading, such as buying on margin or short-selling stocks.
The Bottom Line
Given the volatility that is inherent in financial markets, only investors who have the time to pay attention to these investment vehicles should consider allocating a small portion of their investments into 3x leveraged ETFs. The upside potential looks explosive if you're on the right side of the market movement; however, beware of the compounded negative returns on the other side.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.
