This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
A leveraged product is a financial instrument that produces a multiple of the daily return of an underlying asset. The most common form is a leveraged ETF, which is an exchange-traded fund that holds a portfolio of swaps or futures to deliver the multiple. Other forms include leveraged CFDs, leveraged warrants, and single-stock futures. The mechanics are similar across the category, and the costs are different.
The daily reset
A leveraged product targets a multiple of the daily return, not a multiple of the cumulative return. The distinction is the most important thing to understand. A 2× leveraged S&P 500 ETF aims to deliver twice the daily return of the S&P 500, not twice the annual return. Over a single day, the product is a clean 2× of the S&P 500. Over a week, a month, or a year, the product is not a clean 2× of the S&P 500, and the difference is the source of the well-known "leveraged ETF decay."
The decay is the result of the daily rebalance. At the close of each trading day, the leveraged product rebalances to its target multiple of the underlying. If the S&P 500 rose 1% during the day, a 2× product rises 2%. The next day, the product starts from the new level, and the 2× multiple is applied to that level. If the S&P 500 falls 1% the next day, the product falls 2% from the new level, which is a slightly smaller dollar amount than 2% of the previous day's level.
Over time, the compounding of the daily rebalance produces a return that is below 2× the cumulative return of the S&P 500. The effect is small in a trending market, where the daily returns are mostly in the same direction, and large in a choppy market, where the daily returns reverse frequently. A trader who holds a 2× leveraged S&P 500 ETF for a year in a choppy market can produce a return well below 2× the S&P 500's return, sometimes negative.
How the product delivers the multiple
A leveraged ETF delivers the daily multiple through a combination of swaps and futures. The fund enters into a swap agreement with a counterparty (usually a large bank), where the counterparty pays the fund the daily return of the underlying multiplied by the leverage factor. The fund pays the counterparty a financing rate, which is usually the federal funds rate plus a spread. The fund holds the cash, the swap, and a small amount of the underlying stocks to track the index.
The swap structure is the most common, and it has two main risks. The first is counterparty risk: if the swap counterparty fails, the fund can lose the value of the swap. The second is the financing cost: the spread the fund pays the counterparty is a real cost, and it accrues daily. The financing cost is the most common reason that leveraged ETFs underperform their underlying over long horizons.
A leveraged CFD delivers the multiple through a margin account. The trader puts down a fraction of the position size as margin, and the broker lends the rest. The position is marked to market daily, and the trader's account is credited or debited with the daily return. The financing cost is paid on the borrowed portion, and the cost accrues daily.
The costs
The first cost is the expense ratio. A leveraged ETF charges an annual expense ratio, usually 0.5% to 1.5%, which is higher than the unleveraged equivalent. The expense ratio covers the fund's operating costs, the swap counterparty's spread, and the fund manager's fee. The expense ratio is published in the fund's factsheet, and it is a real drag on the return.
The second cost is the financing cost. For a leveraged ETF, the financing cost is the swap counterparty's spread, which is embedded in the fund's return. For a leveraged CFD, the financing cost is the broker's overnight financing rate, which is published on the broker's product page. The financing cost is paid daily, and it compounds over time.
The third cost is the bid-ask spread. A leveraged ETF trades on an exchange, and the spread is the difference between the bid price and the ask price. The spread is usually wider than the unleveraged equivalent, because the fund has less liquidity. The spread is paid on every trade, and it is a real cost for active traders.
The fourth cost is the tracking error. A leveraged ETF aims to deliver the daily multiple of the underlying, but the realised return is usually slightly different from the target. The difference is the tracking error, and it is the result of the fund's costs, the timing of the rebalance, and the swap counterparty's performance. The tracking error is published in the fund's factsheet, and it is a real drag on the return.
How to use leveraged products
A leveraged product is most appropriate for a short-term tactical position, where the trader has a directional view for a few days and wants to size the position to the view. The trader buys the leveraged product, holds it for the expected duration, and closes the position. The daily reset is not a meaningful drag over a few days, and the financing cost is small.
A leveraged product is less appropriate for a long-term hold, where the trader is using the product as an investment. The daily reset compounds in a way that produces a return below the underlying's, and the financing cost is paid for the entire hold period. The trader is better off holding the unleveraged product, or a long-term leveraged product that is designed for buy-and-hold (with a rebalance policy that is less aggressive than a daily rebalance).
A leveraged product is also useful for hedging. A short position in a 1× inverse product is a clean way to hedge a long portfolio through a known risk window. The cost is the financing rate plus the tracking error, which is usually small for the major indices.
Related resources
Where to start
If you are evaluating a leveraged product for your portfolio, the most useful features to compare are the leverage ratio, the daily reset policy, the financing cost, and the expense ratio. Our broker comparison lists the leveraged products available at each broker and the regulator that supervises the account, which together tell you what the cost and the risk look like before you size the position.