Most exchange-traded funds (ETFs) seek to duplicate the returns of an index or other benchmark. Leveraged exchange-traded funds (ETFs) try to deliver a greater return. As with other ETFs, the investor can choose an ETF that is based on the S&P 500 Index or the Nasdaq 100, or one of many that tracks a specific sector or industry group.

About Leveraged ETFs

Like stocks, shares of ETFs are traded on a public exchange. Like mutual funds, ETFs allow individual investors to benefit from the diversification and economies of scale that come from joining a large pool of money contributed by many investors.

Most ETFs are passive investments. They invest strictly in the stocks, bonds, or other assets that are listed in a particular index such as the S&P 500, buying and selling only when the index is revised.

The First Leveraged ETFs

The first leveraged ETFs were introduced in the summer of 2006, after being reviewed for about six years by the Securities and Exchange Commission (SEC).

Like other ETFs, leveraged ETFs often mirror an index fund, and the fund's capital, in addition to investor equity, provides a higher level of investment exposure. Typically, a leveraged ETF will maintain a $2 exposure or $3 exposure to the index for every $1 of investor capital.

The fund's goal is to have future appreciation of the investments made with the borrowed capital to exceed the cost of the capital itself.

Maintaining Asset Value

Long before ETFs were introduced, the first investment funds that were listed on stock exchanges were called closed-end funds, meaning that the number of shares issued was fixed. Their pricing was set by supply and demand, and often deviated from the value of the assets in the fund, or net asset value (NAV). This confused and deterred many would-be investors.

ETFs solved this problem by allowing management to create and redeem shares as needed. This made the fund open-ended rather than closed-ended and created an arbitrage opportunity for management that helps keep share prices in line with the underlying NAV.

As a result, even ETFs with very limited trading volume have share prices that are almost identical to their NAVs. It's important to know that ETFs are almost always fully invested; the constant creation and redemption of shares can increase transaction costs because the fund must resize its investment portfolio. These transaction costs are borne by all investors in the fund.

Index Exposure

Leveraged ETFs respond to share creation and redemption by increasing or reducing their exposure to the underlying index using derivatives. The derivatives most commonly used are index futures, equity swaps, and index options.

The typical holdings of a leveraged index fund include a large amount of cash invested in short-term securities and a smaller but highly volatile portfolio of derivatives. The cash is used to meet any financial obligations that arise from losses on the derivatives.

There are also inverse-leveraged ETFs that use the same derivatives to attain short exposure to the underlying ETF or index. These funds profit when the index declines and take losses when the index rises.

Daily Rebalancing

Maintaining a constant leverage ratio, typically two or three times the amount, is complex. Fluctuations in the price of the underlying index change the value of the leveraged fund's assets, and this requires the fund to change the total amount of index exposure.

As an example, say a fund has $100 million of assets and $200 million of index exposure. The index rises 1% on the first day of trading, giving the firm $2 million in profits. (Assume no expenses in this example.) The fund now has $102 million of assets and must increase (in this case, double) its index exposure to $204 million. Maintaining a constant leverage ratio allows the fund to immediately reinvest trading gains. This constant adjustment, called rebalancing, is how the fund is able to provide double the exposure to the index at any point in time, even if the index has recently gained 50% or lost 50%. Without rebalancing, the fund's leverage ratio would change every day, and the fund's returns (as compared to the underlying index) would be unpredictable.

In declining markets, rebalancing a leveraged fund with long exposure can be problematic. Reducing the index exposure allows the fund to survive a downturn and limits future losses, but also locks in trading losses and leaves the fund with a smaller asset base.

For instance, say the index loses 1% every day for four days in a row and then gains +4.1% on the fifth day, which allows it to recover all of its losses. How would a two-times leveraged ETF based on this index perform during this same period?

Day	Index Open	Index Close	Index Return	ETF Open	ETF Close	ETF Return
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 end of the week, our index had returned to its starting point, but our leveraged ETF was still down slightly (0.2%). This is not a rounding error. It's a result of the proportionally smaller asset base in the leveraged fund, which requires a larger return, 8.42% to be exact, to return to its original level.

This effect is small in this example but can be significant over longer periods of time in very volatile markets. The larger the percentage drops are, the larger the differences will be. Simulating daily rebalancing is mathematically simple. All that needs to be done is to double the daily index return. What is considerably more complex is estimating the impact of fees on the daily returns of the portfolio.

Performance and Fees

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

Assuming that future returns conform to recent historical averages, the two-times leveraged ETF based upon this index will be expected to return twice the expected return with twice the expected volatility (i.e., 1.8% monthly return with a 4% standard deviation). Most of this gain would come in the form of capital gains rather than dividends.

1. However, this 1.8% return is before fund expenses. Leveraged ETFs incur expenses in three categories: management, interest, and transations.

Management Fees

The management expense is the fee levied by the company that offers the fund. This fee is detailed in the prospectus and can be more than 1% of the fund's assets. These fees cover both marketing and fund administration costs.

All derivatives have an interest rate built into their pricing. This rate, known as the risk-free rate, is very close to the short-term rate on U.S. government securities. Buying and selling these derivatives also results in transaction expenses.

Interest and Transaction Costs

Interest and transaction expenses can be hard to identify and calculate because they are not individual line items but a gradual reduction of fund profitability. One approach that works well is to compare a leveraged ETF's performance against its underlying index for several months and examine the differences between expected and actual returns.

Suppose a two-times leveraged small-cap ETF has assets of $500 million, and the appropriate index is trading for $50. The fund purchases derivatives to simulate $1 billion of exposure to the appropriate small-cap index, or 20 million shares, using a combination of index futures, index options, and equity swaps.

The fund maintains a large cash position to offset potential declines in the index futures and equity swaps. This cash is invested in short-term securities and helps offset the interest costs associated with these derivatives. Every day, the fund rebalances its index exposure based upon fluctuations in the price of the index and on share creation and redemption obligations. During the year, this fund generates $33 million of expenses, as detailed below.

Interest Expenses	$25 million	5% of $500 million
Transaction Expenses	$3 million	0.3% of $1 billion
Management Expenses	$5 million	1% of $500 million
Total Expenses	$33 million	- -

In one year, the index increases 10%, to $55, and the 20 million shares are now worth $1.1 billion. The fund has generated capital gains and dividends of $100 million and incurred $33 million in total expenses. After all the expenses are backed out, the resultant gain, $67 million, represents a 13.4% gain for the investors in the fund. On the other hand, if the index had declined 10%, to $45, the result would be a very different story. Investors would have lost $133 million, or 25% of their invested capital. The fund would also sell some of these depreciated securities to reduce index exposure to $734 million, or twice the amount of investor equity (now $367 million). This example does not take into account daily rebalancing. Long sequences of good or bad daily returns can have a noticeable impact on the fund's shareholdings and performance.

The Bottom Line

Leveraged ETFs, like most ETFs, are simple to buy and sell, but there is far greater complexity behind the scenes. Fund management is constantly buying and selling derivatives to maintain a target index exposure. This results in interest and transaction expenses and significant fluctuations in index exposure due to daily rebalancing. Because of these factors, it is impossible for any of these funds to provide twice the return of the index for long periods of time. The best way to develop realistic performance expectations for these products is to study the ETF's past daily returns as compared to those of the underlying index. For investors already familiar with leveraged investing, leveraged ETFs may have little to offer. These investors will probably be more comfortable managing their own portfolios, and directly controlling their index exposure and leverage ratio.