A leveraged ETF is exchange traded fund that is designed to give the investors better returns by providing them with additional leverage using additional borrowed money. Leveraged ETFs are more sensitive to market changes than most other types of exchange traded funds. While this makes them more profitable than other ETFs when the market is stable and improving, it also make it much more vulnerable to losses in volatile and depressed markets. This is why each investor must decide whether the benefits of leveraged ETFs outweigh the risks.

Leveraged ETF Basics

ETF is an acronym for Exchange-Traded Funds, investment vehicles traded in stock exchanges in the manner similar to stocks. The funds are made up a similarly themed stocks and bonds. While they have many stock-like features, they are cheaper and and place less tax burden on the investors than stocks. 

While most ETFs are traded at the same value as the underlying assets, leveraged ETFs are designed to be traded at greater value so that the investors will get bigger returns. They do this by borrowing more money that is generated using financial engineering techniques such as equity swaps, derivatives and rebalancing. Ideally, the leveraged ETFs are supposed to generate 2-3 times the original value, but the reality is more complicated then that.

Borrowing and Leveraged ETFs

This borrowing involved in generating profit from leveraged ETFs is both it's biggest strength and it's most crippling weakness. As mentioned before, ETFs are designed to be traded in the manner similar to stocks. This means that it's values change daily depending on the market conditions and the financial conditions of the corporate entities that the assets belong to. This, in turn, means that in order to keep generating profit, the amount of money borrowed must change accordingly.

This isn't much of a problem when the market is good, but if the market faces the downturn, the fund's value drops. The fund managers have to sell shares to maintain the value-to-profit ratio. The sale of those shares further undercuts the value of leveraged ETFs, which creates bigger losses then what the borrowers would face with other ETFs in the similar situation. Because the losses are steep, the investors will have tougher time generating profits once the economy improves.

Other Issues With Leveraged ETFs

Aside from it's vulnerability to significant market shifts, leveraged ETFs come with a smaller, but no less noteworthy flaw. One cannot borrow money without transaction costs and management fees. Those costs are usually paid out of the value of leveraged ETFs. This means that the borrowed money isn't adding as much value as it's supposed to, so the investors earn less profit than they expect. The more money is borrowed, the greater the losses. Depending on the value of underlying assets, this may not matter much, but the losses will add up over the years, undercutting long-term profits. Furthermore, they make the losses that occur when the market declines that much more acute.

Weighing pros and cons

Ultimately, it is up to each investors to decide whether the potential benefits of Leveraged ETFs outweigh the risks. If the investor decides to invest in leveraged ETFs, he or she should look at their performance history over the past few years and compare it to the market conditions. This will give the investors some sense of what kind of gains losses they can expect. If the leveraged ETF they are looking at is new, they should wait at least a year and see how it fares under the current economic conditions.

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