Leveraged Exchange-Traded Funds (ETFs)

by Natalie MacLellan on September 14, 2009

in Fraud Prevention

Leveraged ETFs were named among the most problematic on the list of the Top 10 Investor Traps of 2009. What is a Leveraged ETF, and how do they work?

An Exchange-traded fund or ETF is traded on a stock exchange. They allow individual investors to benefit from economies of scale by spreading administration and transaction costs over a large number of investors.

Leveraged ETFs are relatively new and fairly complex. They were first introduced in 2006, after undergoing almost three years of regulatory review. Leveraged ETFs mirror an index fund, but they use borrowed capital in addition to investor equity to provide a higher level of investment exposure. Typically, a leveraged ETF will maintain a $2 exposure to the index for every $1 of investor capital.

For example if 10 people invest $10,000, there is $100,000 of investor capital, and the fund would also borrow another $100,000 to invest in the ETF. So the investor stands gain (or lose) not just from their own investment, but from the borrowed funds as well.

These relatively new financial products have been offered to individual investors who may not be aware of the risks these funds carry. The funds, which trade throughout the day like a stock, use exotic financial instruments, including options and other derivatives, and promise the potential to provide greater than market returns as the value of the underlying assets rise or fall. Given their volatility, these funds typically are not suitable for most retail investors.

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{ 1 comment… read it below or add one }

1 JoeTaxpayer 09.17.09 at 6:42 pm

I wrote about leveraged ETFs some time ago http://www.joetaxpayer.com/etfed/
The issue being they are calculated day to day, but cumulatively they will not return twice the underlying index. An inverse leveraged index, when the underlying index was down 50% for the year did not return 100%, but only 10%, a completely useless ETF for anyone with a time horizon of more than a few days. Imagine being right in forecasting the market and not even getting 1/10 the return you expect.

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