If you’re just starting out as an investor, the chances are you hear a lot about leveraged ETF.
At first, it may look like a complicated concept. But don’t worry. We’re here to break it down for you.
Before we begin, we’re guessing you already have a brief idea about ETF, which is short for an exchange-traded fund. Nonetheless, it is a type of fund that owns the underlying assets such as shares or stocks, foreign currency, gold, futures, and oil, and the ownership of these assets is divided into shares. These ETF shares are bought and sold throughout the day at a price that is higher or lower than the net asset value.
That’s right. But the real question is should you invest in a leveraged ETF?
Let’s explain it to you to help you find your answer.
What Is a Leveraged ETF?
From what we know, the first leveraged ETF was launched in 2006. Although, its earlier version, called the leveraged mutual funds, has been there since at least the 1990s. Today, you’d find as many as 200 leveraged ETFs in the market, but the concept is still new and people are still trying to understand its mechanism.
Since the beginning of the markets, people have always enjoyed investing in stocks on margin. They like to speculate the price of a particular asset and make profits if the prediction turns out to be right. Sounds interesting, isn’t it?
Leveraged ETF is no different. It works on the same concept. It uses borrowed money or futures to increase the exposure and impact the movement of an underlying index or investment in ETF.
Let’s give you an example here. The Direxion Daily S&P 500 Bull 3x leveraged ETF gains 3x movement in the ETF price when the underlying S&P 500 index gains 1x momentum. However, it’s important to note that the leveraged ETF rebalances itself every day. This means if you buy and hold it, and the benchmark moves up and down drastically along the way, you may lose a significant percentage of the value of the ETF. That’s because of the compounding effects of daily returns.
Let’s warn you. It may look tempting to invest in leveraged ETF given its high potential returns. But don’t go anywhere near it if you’re just a beginner. You won’t know what to look for while researching. And this may end up piling a huge loss on your account.
And if you’re someone who likes to invest in a diversified, long-term portfolio, again stay away from leveraged ETFs. By now, it must be pretty clear to you that leveraged ETFs are not for long terms. Regardless of whether you’re experienced or not, even if you invest in a right leveraged ETFs, the trend is bound to change. And when that happens, you will lose a substantial amount of your money.
The Bottom Line
Leveraged ETFs are for short-term plays on an index. And trust us, if you don’t do it right, it’ll take away your capital in more ways than you can imagine. It includes investment management fees and also, brokerage commission in many cases. And if you’re an investor in the top Federal bracket who also happen to live in a high-tax state such as New York or California, your profit may be short-lived as the tax may reach up to 40% to 50% of your capital gain.
Is Taking the Risk Worth it?
We’d say, when you have other simpler way of building wealth such as investing in blue chip stocks, you should avoid the high-risk marketable securities.