What are the hottest investments currently on Wall Street? You’d be surprised, but the answer is leveraged exchange traded funds (ETF’s). In March alone, over 3.5 billion of new funds poured into these type of investments according to the WSJ. Leveraged ETFs offer double or even triple the daily return of a market index. Some of them, called “inverse” ETFs, move opposite to the market – for example, going up twice as much as an index goes down. Each day, they all adjust their exposure by re-balancing, or “re-leveraging,” their positions.
How they work: Leveraged ETFs usually generate a multiple of the market’s daily return by using something called a “total-return swap.” Imagine a fund with $100 million in net assets and 200% leverage, meaning that it seeks to deliver twice the market’s daily return. That requires the fund to maintain $100 million in swap exposure. In a long swap, a counter party like a bank or brokerage firm agrees to pay the fund $2 for every $1 rise in the closing value of a market index that day. On the other hand, if the market falls, the fund must pay the counter party 2-for-1.
From an investor perspective though, you can treat leveraged ETF’s like any other ETF/stock that you buy through your online broker. The key is understand how you can make money via the ETF from movements in the underlying index. Here’s an example from my own personal trading experience using Proshares Ultra Financials (UYG) and UltraShort Financials (SKF). These two leveraged ETF’s seek to provide twice the daily performance of the Dow Jones U.S. Financials index. If you think the index is going to rise (i.e. financial stocks doing well) then you would buy UYG, alternatively if you think things are going to get worse you would buy SKF (where you make money if the index falls). The thing I like about these ETF’s are that they are heavily traded so have a lot of volume and selling/buying is never an issue. Also, unlike options they do not expire and given the massive volatility in the financial markets, I have found you will eventually make money with them. My rule has been to sell whenever they go up by around 40 to 50%. For the last 3 months this has worked very well for me and I have made about $9,000 buying and selling these stocks with my low cost broker.
Other leveraged ETF’s that I am going to start looking into are related to technology and resources sector, which I think are going to boom in the next 6 months. For these two sectors, I am focusing primarily on the upside ETF’s – ProShares Ultra Technology ETF (ROM) and Ultra Oil & Gas (DIG). For a full list see the table here from Proshares, the biggest provider of these types of ETFs.
Like any investment leverage ETF’s have an element of risk and do not trade them unless you have the time and know what you are doing. To understand them better, do some research via the Morningstar fund research website and then follow them for a few days to understand how they work. My final piece of advise is not to get greedy when a market rallies in a way that favors your leveraged ETF position. Your gains are multiplied, but so are your losses if the index/market turns the other way. So sell when you make profits, because you will surely get another chance to buy in again.