Analysis of leveraged ETF returns

Leveraged exchange-traded funds (ETFs) are designed to provide higher returns than those of holding long or short positions in conventional ETFs. Leveraged ETFs were created to provide long or short exposure to benchmarks such as the S&P 500 Index or the Nasdaq 100, while others are designed to move with specific industries or industry groups.

In this article, we will extensively explain the meaning of leveraged ETFs and how these investments operate under good and bad market conditions.

About leveraged ETF

ETF shares are traded on stock exchanges like stocks. ETFs allow individual investors to benefit from economies of scale by sharing management and transaction costs among a large number of investors. After nearly three years of review by the US Securities and Exchange Commission (SEC), the first batch of leveraged ETFs were launched in the summer of 2006.

Key points

  • Leveraged ETFs are designed to provide higher returns than ordinary exchange-traded funds.
  • By relying on derivatives, leveraged ETFs try to move two to three times the benchmark index (or vice versa).
  • One disadvantage of leveraged ETFs is that the investment portfolio is constantly rebalanced, which increases costs.
  • By directly controlling index exposure and leverage ratios, rather than through leveraged ETFs, it is possible to provide better services for experienced investors to manage their investment portfolios.

Leveraged ETFs usually reflect index funds. In addition to investor equity, the fund’s capital also provides a higher level of investment exposure. Generally, for every dollar of investor capital, leveraged ETFs will maintain index exposures of $2 or $3. The goal of the fund is to make the future appreciation of the borrowed capital investment exceed the cost of the capital itself.

Maintain asset value

Long before the emergence of ETFs, the first investment funds listed on the stock exchange were called closed-end funds. One problem with closed-end funds is that the pricing of fund shares is determined by the relationship between supply and demand, and often deviates from the value of the fund’s assets or the net asset value (NAV). This unpredictable pricing has confused and discouraged many potential investors.

The ETF solves this problem by allowing management to create and redeem stocks as needed. This makes the fund open rather than closed, and creates an arbitrage opportunity for management, helping to align the stock price with the underlying net asset value. Therefore, the stock price of an ETF with very limited trading volume is almost the same as its net asset value.

It is important to know that ETFs are almost always fully invested; the constant creation and redemption of stocks may indeed increase transaction costs because the fund must adjust the size of its investment portfolio. These transaction costs are borne by all investors in the fund.

Although all ETFs have fees, many ETFs are designed to track indexes, and the fees or expenses are usually much less than that of actively managed mutual funds.

Exponential Exposure

Leveraged ETFs respond to stock holdings and redemptions by using derivatives to increase or decrease their exposure to the underlying index. The most commonly used derivatives are index futures, stock swaps and index options.

Typical holdings of leveraged index funds include large amounts of cash invested in short-term securities and smaller but highly volatile derivatives portfolios. Cash is used to fulfill any financial obligations arising from the loss of derivative instruments.

There are also some reverse leveraged ETFs that use the same derivatives to gain short exposure to the related ETF or index. These funds profit when the index falls and lose money when the index rises.

Daily rebalance

Maintaining a constant leverage ratio (usually two or three times) is very complicated. Fluctuations in the price of the underlying index will change the value of leveraged fund assets, which requires the fund to change the total amount of index exposure.

For example, a fund has assets of 100 million U.S. dollars and index exposure of 200 million U.S. dollars. The index rose by 1% on the first day of trading, bringing the company $2 million in profits. (Assume that there are no expenditures in this example.) The fund now has assets of $102 million and must increase its index exposure (in this case, twice) to $204 million.

Maintaining a constant leverage ratio allows the fund to reinvest the trading proceeds immediately. This continuous adjustment, also known as rebalancing, is how the fund can provide double exposure to the index at any point in time, even if the index has recently risen by 50% or fallen by 50%. If it is not re-adjusted, the leverage ratio of the fund will change every day, and the fund’s return (compared to the relevant index) will be unpredictable.

However, in a declining market, rebalancing leveraged funds holding long positions may be problematic. Reducing index exposure can allow the fund to survive the downturn and limit future losses, but it can also lock in trading losses and allow the fund to have a smaller asset base.

For example, suppose the index fell by 1% every day for four consecutive days, and then rose by 4.1% on the fifth day, which allows it to cover all losses. How did the double leveraged ETF based on this index perform during the same period?

day Index opening Index closed Index return ETF is open ETF closed ETF returns
on Monday 100.00 99.00 -1.00% 100.00 98.00 -2.00%
Tuesday 99.00 98.01 -1.00% 98.00 96.04 -2.00%
Wednesday 98.01 97.03 -1.00% 96.04 94.12 -2.00%
Thursday 97.03 96.06 -1.00% 94.12 92.24 -2.00%
Friday 96.06 100.00 +4.10% 92.24 99.80 +8.20%

By the weekend, our index had returned to the starting point, but our leveraged ETF still fell slightly (0.2%). This is not a rounding error, but the result of a smaller proportion of the asset base in the leveraged fund, which requires a larger return, which is actually 8.42%, to return to the original level.

In this example, the impact is small, but it will become significant over time in a very volatile market. The greater the percentage drop, the greater the difference.

Simulating daily rebalancing is mathematically simple. All that needs to be done is to double the daily index return. More complicated is the effect of estimating fees on the daily return of the portfolio, which we will cover in the next section.

Performance and cost

Suppose an investor analyzes the monthly returns of the S&P 500 Index over the past three years and finds that the average monthly return is 0.9%, and the standard deviation of these returns is 2%.

Assuming that future returns are in line with recent historical averages, the expected return of a double-leveraged ETF based on the index will be twice the expected return, with volatility twice the expected (i.e. monthly return of 1.8%, standard deviation of 4%) . Most of the gains will come in the form of capital gains rather than dividends.

However, this 1.8% return is forward Fund fees. Leveraged ETFs incur three types of expenses:

  1. manage
  2. interest
  3. trade


Management fees are fees charged by fund management companies. This fee is detailed in the prospectus and can be as high as 1% of the fund’s assets each year. These expenses include marketing and fund management expenses. Interest expense is the cost associated with holding derivative securities.

The pricing of all derivatives includes interest rates. This interest rate is called the risk-free interest rate and is very close to the short-term interest rate of US government securities. Trading these derivatives will also incur transaction costs.

Interest and transactions

Interest and transaction costs may be difficult to identify and calculate, because they are not separate items, but a gradual decrease in the profitability of the fund. One effective method is to compare the performance of leveraged ETFs over several months with their underlying indexes and check the difference between expected and actual returns.

Suppose a small-cap ETF with twice the leverage has assets of US$500 million, and the corresponding index transaction price is US$50. The fund uses a combination of index futures, index options, and stock swaps to purchase derivatives to simulate an appropriate small-cap index of $1 billion or exposure to 20 million shares.

The fund maintains a large cash position to offset potential declines in index futures and stock swaps. This cash is invested in short-term securities to help offset the interest costs associated with these derivatives. On a daily basis, the fund rebalances its index exposure based on fluctuations in index prices and stock holdings and redemption obligations. During the year, the fund incurred USD 33 million in expenses, as detailed below.

Interest expense USD 25 million 5% of USD 500 million
transaction fee US$3 million 0.3% of USD 1 billion
Management costs USD 5 million 1% of 500 million USD
Total cost 33 million USD

A year later, the index rose 10% to $55, and the 20 million shares are now worth $1.1 billion. The fund generated US$100 million in capital gains and dividends, with a total expenditure of US$33 million. After recovering all expenses, the resulting income was 67 million USD, representing 13.4% of the fund’s investors’ income.

On the other hand, if the index drops by 10% to $45, the result will be a very different story. Investors will lose 133 million U.S. dollars, or 25% of invested capital. The fund will also sell some of these depreciated securities to reduce index exposure to $734 million, which is twice the amount of investor equity (currently $367 million).


ProShares UltraPro Short QQQ ETF is one of the more actively traded leveraged funds; traded under the stock code SQQQ, the fund aims to change three times the daily change of the Nasdaq 100 index.

This example does not take into account daily rebalancing, and long-term sequences of high or low daily returns usually have a significant impact on the fund’s holdings and performance.

Bottom line

Like most ETFs, leveraged ETFs are simple to use, but hide considerable complexity. Behind the scenes, fund management continues to buy and sell derivatives to maintain target index exposure. Due to daily rebalancing, this can cause significant fluctuations in interest and transaction costs, as well as index risk.

Because of these factors, none of these funds can provide returns that are twice the index in the long term. The best way to formulate realistic performance expectations for these products is to study the past daily returns of the ETF compared with the returns of the relevant index.

For investors who are already familiar with leveraged investment and have access to related derivatives (such as index futures, index options, and stock swaps), leveraged ETFs may not have much to offer. These investors may be more willing to manage their investment portfolios and directly control their index exposure and leverage.


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