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In India, exchange-traded funds, or ETFs, are becoming increasingly popular. Leveraged ETFs, on the other hand, are a riskier kind of ETF that has become more common globally in recent years.
Leveraged exchange-traded funds provide a tempting opportunity to increase your profits from fluctuations in the market. These funds seek to increase returns from an underlying index or asset by two, three, or more times through debt and derivatives.
However, the drawbacks are as severe. While leveraged ETFs are presently prohibited in India owing to regulatory limitations, they offer Indian traders exposure to worldwide assets and are widely accessible in foreign markets.
What is a leveraged index ETF?
The primary goal of ETFs is to provide investment results similar to those of an index or equivalent benchmark. On the other hand, the purpose of leveraged exchange-traded funds is to provide higher returns.
If you want to invest in an exchange-traded fund that follows the NIFTY 50, it will hold all 50 stocks that make up the index, with their weights adjusted so that the ETF will react similarly to the index’s ups and downs.
Leveraged exchange-traded funds are an investment vehicle that utilises debt and financial derivatives to increase the potential returns of an underlying asset or index. In contrast, non-leveraged ETFs solely invest in stockholders’ equity.
Managers of leveraged exchange-traded funds strive for daily gains that exceed the performance of the fundamental asset or index by a multiple. Here, making a higher profit than the cost of the assumed debt should be your priority.
A leveraged exchange-traded fund can achieve a certain return-to-index ratio using derivatives and margin. Suppose a 4x leveraged ETF that follows the NIFTY 50 will try to make 8% if the index rises 2% in a single day.
On the flip side, a 1% decline in the NIFTY 50 will result in a 3% loss for the triple-leveraged ETF. 2x leveraged ETFs and 4x leveraged ETFs require careful management by investors to prevent tracking mistakes and significant losses.
How to trade leveraged ETFs?
The day trading community has become increasingly fond of leveraged exchange-traded funds due to the high rate of return these funds may deliver if the trader is correct. Leveraged exchange-traded funds are primarily designed for speculating in the short term.
Leveraged ETFs may attempt to achieve their stated investing objectives by employing advanced financial instruments and approaches. Certain ETFs, for instance, could use swaps, options, futures contracts, short positions, or other derivatives, exposing the fund to all the risks involved with such complex financial instruments.
Long-term leveraged ETF strategy
The tracking error is a factor that makes leveraged ETFs underperform in the long run. The fund issuer resets its holdings daily due to using derivatives to improve leverage.
Because of this, leveraged ETFs eventually deviate from their benchmark index, which can cause excessive losses if not properly evaluated. These investors do not retain any security for longer since they primarily trade in derivatives of underlying equities.
Do leveraged ETFs carry any risk?
Leverage increases the risks associated with leveraged ETFs considerably compared to ETFs or mutual funds. Leverage significantly multiplies both gain and downside, so even modest market movements can convert into massive profits or losses, as their daily goal is to multiply returns.
For instance, traders are going to lose 20% in one day if a 2x bullish ETF tracking the Nifty 50 loses 10%.
Additionally, leveraged ETFs strive to provide leveraged exposure to daily market movements; they do not monitor long-term results. Gains can be significantly reduced over time by daily compounding effects and volatility.
Because most traders’ holding periods are short, these consequences are not as severe. However, there’s a significant risk associated with volatility drag over extended holding periods.
Conclusion
While tempting for their ability to generate explosive gains, leveraged ETFs carry exceptional risks that cannot be ignored. Their leverage, achieved through derivatives, acts as a double-edged sword that cuts just as deeply in market downturns.
These products are best used by experienced traders for short-term trades. Long-term investors should steer clear due to the impacts of volatility decay and compounding. When using leveraged ETFs that can magnify gains and losses, it’s extremely important to be cautious and manage your risk properly.
FAQs
In the Indian context, leveraged ETFs are not currently legal, although they are available on international marketplaces. They offer the potential for amplified returns by using financial derivatives and debt instruments to magnify the performance of an underlying index. However, they also come with higher risks and costs, such as a significant potential for loss and a high expense ratio. They are typically used for short-term trading due to their volatility and are not recommended for long-term investment strategies.
The choice between 3x and 2x leveraged ETFs depends on the investor’s risk tolerance and investment goals. A 3x leveraged ETF aims to provide three times the daily return of its underlying index, while a 2x leveraged ETF aims to double the daily return. The 3x ETFs are more aggressive and carry a higher risk and potential for higher returns, but also greater losses. The 2x ETFs are less volatile and may be more suitable for investors with a lower risk appetite.
Leveraged ETFs can theoretically go to zero if the underlying index suffers a significant enough drop in a single day, especially for 3x leveraged ETFs, where a 33% drop could wipe out the value. However, such drastic drops are rare. More commonly, if a leveraged ETF loses most of its value, it might undergo a reverse split or be redeemed to prevent the value from actually reaching zero.
Leveraged ETFs can be appealing for their potential for high returns, but they are complex financial instruments with a high level of risk. They are not suitable for all investors, especially in India, where they are not legally available for trading. They are generally considered more appropriate for experienced traders with a high-risk tolerance and short-term trading strategies due to their inherent volatility and potential for significant losses.
The appropriate level of leverage in an ETF depends on the individual investor’s risk tolerance and investment strategy. Generally, leverage of up to 2x is considered manageable for more investors, while 3x leverage introduces a higher degree of risk. It’s important to note that higher leverage can amplify both gains and losses, and investors should be cautious of leverage levels that exceed their comfort zone or financial capacity.
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