Are The Risks Associated With Leveraged ETFs Worth It?

The popularity of exchange-traded funds (ETFs) has risen steadily in India over the past few years. With their ability to offer diversification, transparency, and cost-effectiveness, ETFs have found favour among retail and institutional investors alike. However, a more complex and high-risk variation known as leveraged ETFs is now attracting attention globally, though it remains out of bounds for direct retail investment in India due to regulatory limitations.

If you are an investor with exposure to global markets or have access through international brokers, you might have come across the concept of leveraged ETFs. You may even be wondering, are the risks associated with leveraged ETFs truly worth it?

This article provides an in-depth look into what leveraged ETFs are, their potential benefits and downsides, and what you should keep in mind if you’re thinking of including them in your investment strategy.

What Are Leveraged ETFs?

Leveraged ETFs are a type of exchange-traded fund that aims to deliver multiple times the daily return of a particular benchmark index, such as the Nifty50, S&P 500, or NASDAQ. These funds achieve magnified returns using financial derivatives like futures, options, swaps, and debt instruments.

The leverage involved is typically expressed as a multiple. For example:

• A 2x leveraged ETF targets double the index’s daily performance.
• A 3x leveraged ETF targets thrice the daily return.

If the underlying index gains 1% in a day, a 2x leveraged ETF may gain approximately 2%. However, the reverse is also true, losses are equally magnified.

It is important to note that leveraged ETFs reset daily. This means the multiple applies only to daily performance, and not to long-term returns. This daily reset mechanism can lead to compounding effects over time, especially in volatile markets.

Benefits Of Investing In Leveraged ETFs

While leveraged ETFs carry considerable risk, they also offer some distinct advantages. If you are an investor with high-risk tolerance and short-term trading goals, these benefits may be attractive.

1. Potential For High Returns

The primary appeal of leveraged ETFs is their amplified return potential. For example, if you believe a particular sector or index will rise in the short term, a leveraged ETF offers a way to magnify your profit. A 2% increase in the underlying index could result in a 4% or 6% return, depending on the leverage factor.

2. Access Without Margin Borrowing

In traditional margin trading, you borrow money to buy more securities, which can lead to debt beyond your initial investment. Leveraged ETFs provide a way to access this leverage without borrowing on margin. Your maximum loss is limited to your investment amount.

3. Highly Liquid

Most leveraged ETFs are listed on major stock exchanges and are highly liquid. This makes them suitable for intraday traders or short-term investors looking to enter or exit positions swiftly.

4. Diversified Exposure 

Many leveraged ETFs track well-known indices or sectors, providing diversified exposure to multiple companies through a single instrument. This reduces the need to select individual stocks while still participating in a broader market trend.

5. Cost Efficiency Compared To Other Leverage Methods

Though leveraged ETFs have higher expense ratios than traditional ETFs, they may still be cheaper than taking leveraged positions through futures or options, especially for retail investors who do not have access to institutional-grade tools.

Downsides of Leveraged ETFs

1. Amplified Losses

The same leverage that increases returns also magnifies losses. A 2% decline in the benchmark could translate into a 4% or 6% loss, depending on the leverage factor. 

2. Short-Term Focus Only

Leveraged ETFs are designed for daily performance tracking, not long-term investing. Holding these instruments for more than a few days can lead to unpredictable results due to volatility drag, a phenomenon where returns diminish over time because of compounding daily losses and gains.

3. Complexity Of Derivatives

These funds rely heavily on derivative instruments, which are not always straightforward to understand. Without a proper understanding of how futures, swaps, or options function, you could end up making uninformed decisions.

4. High Expense Ratios

Leveraged ETFs tend to be actively managed, and this comes at a cost. Expense ratios are usually higher than those of passive ETFs. Over time, these fees can lessen gains, especially if your investment is not giving strong returns.

5. Regulatory Restrictions

Currently, SEBI does not permit the launch or sale of leveraged ETFs for Indian retail investors within domestic exchanges. If you wish to invest in them, you will need access to international markets, usually via overseas brokerage platforms. This process involves additional costs, including currency conversion and foreign transaction fees.

Additional Read: ETF vs Index Funds: The Key Difference You Must Know

What You Should Consider Before Investing in Leveraged ETFs?

If you are still thinking about investing in leveraged ETFs, here are a few essential factors to consider:

Assess Your Risk Tolerance

Ask yourself how much risk you are comfortable taking. Leveraged ETFs are not suitable for conservative or long-term investors. If you cannot monitor your investments closely or accept the possibility of sharp losses, these products are not advisable.

Determine Your Investment Horizon

These ETFs are not meant for buy-and-hold investing. Holding them over weeks or months can result in unexpected returns due to the effects of compounding. Most traders who use leveraged ETFs hold them for a day or two at most.

Understand The Underlying Index

Before you buy a leveraged ETF, make sure you understand the benchmark it tracks. If you're unfamiliar with how the S&P 500, NASDAQ, or Nifty50 behaves, you should avoid betting on its movements.

Evaluate The Costs Involved

Expense ratios, administrative charges, and brokerage fees can eat into your returns. You must calculate the total cost of owning the ETF, especially if you're trading through international platforms.

Stay Informed Of Global Regulations

Since these ETFs are currently unavailable in India, you will need to use a foreign brokerage account. Be aware of regulatory requirements, currency fluctuation risks, and tax implications before proceeding.

Check The Fund Prospectus And Strategy

Different leveraged ETFs use various strategies. Some may focus on equities, others on commodities, or even currencies. Always read the fund prospectus to understand its goals, investment strategy, and associated risks.

Should You Invest In Leveraged ETFs?

The decision depends entirely on your investment experience, goals, and risk appetite. If you are a retail investor looking for a long-term investment product, leveraged ETFs are likely not suitable for you. On the other hand, if you have access to global markets, understand short-term trading strategies, and are willing to actively monitor your portfolio, you might consider allocating a small portion of your funds to these instruments.

However, you should not treat leveraged ETFs as a core part of your financial plan. They are more appropriate for short-term trading or speculation rather than wealth-building.

Conclusion

Leveraged ETFs offer a powerful yet risky investment opportunity. Their ability to provide amplified daily returns without margin borrowing is appealing, especially for experienced short-term traders. However, the risks are high and complex. Daily rebalancing, volatility drag, higher fees, and compounding effects make them unsuitable for most long-term investors.

For Indian investors, the added layer of complexity involving access to international markets, regulatory restrictions, and currency risks makes leveraged ETF investment even more challenging. If you are keen on short-term trading and comfortable with the associated risks, you may explore this asset class cautiously. 

Additional Read: ETF vs Index Funds: The Key Difference You Must Know