There exists a niche set of financial traders who trade in leveraged exchange-traded funds. Known as 3x ETF, triple leveraged ETF, these ETFs can provide three times or 3x the daily or monthly performance of the index it tracks.
What are Exchange Traded Funds (ETFs)?
ETFs are a lot like mutual funds. They pool the financial resources of multiple investors and use those pooled funds to purchase a variety of monetary assets like shares, derivatives, bonds and other securities. So far, they seem similar to mutual funds, don’t they? The difference lies in the fact that unlike mutual funds, ETFs are not actively managed by fund managers. And unlike mutual funds, ETFs are listed on stock exchanges. So, they can also be easily bought and sold on those exchanges, just like shares.
What is a 3x ETF?
Let’s take a brief look at what an ETF means to understand what a 3x ETF means.
An exchange-traded fund or ETF is a basket of securities such as stocks, that tracks an underlying index. For example, a NIFTY 50 ETF consists of stocks from the 50 companies listed on the NIFTY index. The performance of the ETF will closely resemble the performance of the NIFTY index. Just like individual stocks, the stocks of the ETF are also listed on the exchange and can be traded throughout the trading day.
So, what does a 3x ETF mean? As you may have guessed, a 3x ETF will give the investor three times the performance of the index it tracks. This means that if the index gains 1 point, the 3x ETF holder will gain 3 points. Naturally, the same applies for a loss. If the index loses 1 point, then the 3x ETF holder incurs a 3x loss.
Typically, the trader will trade in 3x bull ETFs which means that they are counting on the growth of the market to increase their profits.
3x ETFs come with a higher expense ratio compared to traditional ETFs. So, remember that a significant part of your returns will be taken as a fee by the fund manager.
How does a 3x ETF work?
You may now be thinking about how a 3x ETF amplifies its performance. To get a 3x performance, the ETF invests in more than equities. It invests in futures contracts, options, forward contracts, swap agreements, reverse repurchase agreements, equity caps and such complex financial instruments.
Now, let’s take a simple example to see how the performance of the index that the 3x ETF is tracking affects the ETF’s returns.
Say Mr XYZ has placed Rs. 100 in a 3x ETF. What happens when the price of the index goes up 5 percent one day and down 5 percent on the next trading day? The 3x leveraged fund goes up 15 percent (since it is three times whatever is the direction of the change) and down 15 percent on the consecutive days. At the end of the first trading day, the initial Rs.100 investment is worth Rs. 115. At the end of the second trading day, the initial investment is now valued at Rs.97.75. This means there was a loss of 2.25 percent on the investment.
It is this feature of compounding loss that compels traders to buy and sell in the short-term. 3x ETFs are typically held for only a day or week to decrease the risk of compounding losses which can result in the trader/ investor losing all their principal investment.
For whom is a 3x ETF suitable?
You may have concluded for yourself that a 3x ETF is not ideal for those looking to invest in low-risk, long-term securities and trying to build their retirement fund. However, someone with the following characteristics can consider a 3x ETF as part of their trading strategy:
- Is market savvy; knows how the market works
- Has the time and energy to actively manage their investment
- Can take a loss
- Understand short-term trading
Essentially, a 3x ETF should be considered by someone who has extensive knowledge and understanding of the financial markets; has relatively expendable funds; the strength to take a potential hit.
What is ETF liquidity?
ETF liquidity is the ease with which a particular Exchange Traded Fund (ETF) can be bought and sold on the exchange. Since ETFs are basically baskets of multiple assets, the concept of ETF liquidity is also multi-layered. Broadly speaking, ETF liquidity has two main components.
– The liquidity of the ETFs traded on the exchange
– The liquidity of the individual assets in an ETF
Generally, the more liquid the individual assets that make up an ETF are, the easier it is to redeem the ETF itself. This establishes a direct relationship between the liquidity of the constituent assets and the liquidity of the ETF itself.
ETFs in the primary and secondary market
Exchange Traded Funds can be traded in the primary as well as the secondary markets, just like shares. Typically, only institutional investors trade in the primary market through Authorised Persons (APs). These are investors with deep pockets, and they trade in tens of thousands of units at a time. Such heavy-duty transactions have the capacity to influence the supply of ETFs in the secondary market, because institutional investors either acquire or redeem a large basket of assets through ETFs.
In the secondary market, non-institutional investors or retail investors primarily trade through the exchanges, just like how shares are bought and sold. There are many factors that influence ETF liquidity in the primary and secondary markets.
What are the elements that influence the liquidity of ETFs?
There are primarily four factors that influence the liquidity of ETFs.
The way the ETF is composed
ETFs invest in multiple asset classes. Equity ETFs, for instance, may replicate specific indices like large-cap, small-cap or growth indices. Other ETFs may focus on market sectors like real estate or IT. The general liquidity of the assets that make up an ETF influence its liquidity.
This is also true regarding ETF liquidity risk. The lower the investment risk of an asset, the more liquid it is. This basically lowers the ETF liquidity risk on the whole, since it is easier to buy or sell such funds.
The trading volume of the assets in the ETF
Trading volume is influenced by supply and demand forces. Low risk securities are more in demand, and so, they are easier to trade. This often translates to a high trading volume. And if the trading volume of the constituent assets in an ETF is high, the ETF’s overall liquidity goes up. We will discuss more on ETF liquidity later in this article.
The ETF’s own trading volume
In addition to the trading volume of the constituent assets, the ETF itself has its own trading volume. This is influenced by the general category of assets that the ETF basket consists of. For instance, large-cap ETFs may be traded more frequently than small-cap ETFs. This results in lower liquidity for the latter than the former.
The general investment ecosystem
The overall market sentiment, the trends shaping up the specific sectors associated with the ETF, and the general state of the economy may also temporarily influence ETF liquidity. For investors looking to invest in Exchange Traded Funds, it’s a good idea to take all of these factors into consideration.
By now, you know that investing in 3x ETFs is only for those who have a high-risk appetite. So, if you believe that 3x ETFs have a place in your investment portfolio, head to Angel One, one of India’s leading brokerage houses for professional guidance.