Facebook
Twitter
Leveraged ETFs do carry more market risk than conventional ETFs, but if you know how to use them and what to look for, you can add a powerful tool to your investment toolkit.
Like most other ETFs, leveraged ETFs are funds that trade like stocks and track a target benchmark like index mutual funds. But the primary difference, compared to conventional ETFs, is that these alternative ETFs will use debt and financial derivatives, hence the term leverage, to magnify the performance of the benchmark index.
Leveraged ETFs will have stated leverage ratios that they aim to accomplish. They’ll also have a bullish bet and the fund name will usually include terms like Ultra, 2X, 3X or Double Long.
For example, in theory, the Direxion Daily Gold Miners Bull 3x ETF (NUGT) would rise 3% if the price of gold rose 1%. But if gold declines 1%, NUGT would fall 3%.
There’s also an opposite form of funds to leveraged ETFs. They’re called inverse ETFs because they’ll move in the opposite price direction as their respective target benchmark. In different words, inverse ETFs will use derivatives to profit when the benchmark index is in decline.
How to Use Leveraged ETFs
Before even thinking about using leveraged ETFs, you are wise to consider them as only ultra-short-term trading vehicles. Although holding periods of a few months can be suitable for some investors with high risk tolerance, holding leveraged ETFs for more than a day or two is not advisable.
For example, if you had purchases shares of NUGT at the beginning of 2016, you’d be sitting on a price gain of about 300% by mid-year. But this period was a rare bullish run for gold and leveraged ETFs like NUGT can see one-week declines of 10% or more.
Possible Plays With Leveraged ETFs Now
Now is a difficult time to be bullish on stocks and if you feel the same, you’d want to avoid leveraged ETFs, such as Direxion Daily Financial Bull 3x Shares ETF (FAS), that make bullish bets on the major stock market indices.
If you wanted to make a bearish bet, one of the largest inverse leveraged ETFs is UltraPro Short S&P 500 (SPXU), which is a 3X inverse equity fund.
If you feel there is more economic uncertainty and challenges on the horizon, another choice is to use gold leveraged ETFs like NUGT; they could have more room to run.
Tips and Cautions on Leveraged ETFs
To reiterate, leveraged ETFs are not suitable for most investors because the market risk is substantial. And even for those investors with high relative tolerance for risk, the total allocation to leveraged ETFs should not exceed 5 to 10% of portfolio. Keep in mind that these alternative ETFs are designed to short-term trading tools, not long-term investment vehicles.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally does not hold any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.