For the bold investor in the financial market looking to amplify their investment’s performance, the traditional stocks and bonds hold a little less appeal. These ambitious and meticulous investors prefer a different brand of investment vehicle known as ‘leveraged exchange-traded fund’ or leveraged ETF.
What are leveraged ETFs?
Before we delve into what a leveraged ETF is, let’s do a quick revision on what an ETF is. An ETF is a bunch of securities of a similar nature that gets traded on the stock exchange. For instance, a pharmaceutical ETF will consist of stocks of companies that primarily research or manufacture pharmaceuticals.
So, where does the ‘leverage’ bit come in, and why is it important?
Just like an ETF, a leveraged ETF tracks the performance of the asset class or a benchmark index. However, it amplifies the returns by employing debt instruments and derivatives such as futures, options, swaps, reverse repurchase agreements, amongst others.
Pros and cons of investing in leveraged ETFs
Just like any other investment vehicle, leveraged ETFs also come with its fair share of pros and cons. Let’s explore both:
Pros of investing in leveraged ETFs:
- No need for margin borrowing
Say a keen investor believes that the value of gold is going to increase significantly soon and wants to invest in a gold ETF. However, they lack the funds for it. In such a case, they would have probably borrowed on a margin from their broker against collateral. In the unfortunate circumstance that they incurred losses on their investment, they would have lost their principal amount and would have to give up their collateral as well. Investing in leveraged ETFs saves the investor from this additional loss. The investor loses only the principal investment amount.
- High liquidity
You can withdraw your investment and quickly get the cash for it. This will help you in case you need urgent cash inflow. This is opposed to long-term investment where your funds are locked-in and cannot be easily converted into cash.
It is not easy for a retail investor to access assets like real estate. But with a leveraged ETF, they can access these alternative investments by making minimum investments.
- Amplified returns
The investor can receive up to 3 times the amount they invested if the index gains. This salient benefit makes a leveraged ETF quite appealing to a niche group of traders and investors.
Cons of investing in leveraged ETFs:
- High expense ratio
A leveraged ETF is actively managed and requires tons of research and professional insight. The fund manager charges a relatively higher management fee, often thrice the expense ratio that an unleveraged ETF would entail. This can cut into the returns for the investor in case of a profit.
- Risk of a significant loss
Just like an amplified return, the loss too can be multiplied. If the index loses 1 point, the leveraged ETF can lose up to 3 points.
Now that you know the pros and cons of a leveraged ETF let’s see what the minimum research you need to do is should you decide this investment option.
Things to consider before investing in a leveraged ETF
Before you invest in a leveraged ETF, it is wise to think along the following factors to ensure you are making an informed decision:
1. Understand how much of your investment portfolio do you wish to dedicate to a leveraged ETF. Consider your risk appetite here.
2. Find out the costs involved- management fee, admin fee, the overall expense ratio.
3. Understand what sectors and indexes with which you are most familiar. For instance, if you know and understand information technology, then investing in a leveraged ETF that tracks an IT index makes more sense.
4. Review the past performance of the fund in which you wish to invest. Fair caveat: past performance doesn’t determine future performance; it is only indicative at best.
5. Understand the objectives of the leveraged ETF in which you want to invest. You can check out the fund’s prospectus to get a better idea.
As you may have understood, investing in leveraged ETFs is no child’s play. If you think you have the risk appetite and funds to gain from leveraged ETFs, head to Angel One, one of the leading brokerage houses in India to benefit from their professional advice.