Few asset classes are as seductive as leveraged exchange-traded funds (ETFs). Other than leveraged ETFs, where else in the fund universe (without using options) can investors make a bet on a simple index, such as the S&P 500 or Nasdaq-100 Index, and amplify those benchmarks’ gains to the tune of 200% or even 300% in a single trading day?
For traders new to leveraged ETFs, this is how, in a perfect world, leveraged ETFs should work. Say a trader buys the Direxion Daily S&P 500 3X Shares (NYSEARCA:SPXL) and the S&P 500 rises 1% that day. SPXL should increase by 3%.
Here is where things get tricky and potentially punishing with leveraged ETFs, both bullish and bearish funds. Greed is a powerful emotion and it compels some traders to hold leveraged ETFs for more than a single day. Holding these products for a few days usually is not a big deal, but when the holding periods span into weeks and months, things can get hazardous to traders’ accounts.
ProShares and Direxion, the two largest U.S. issuers of leveraged ETFs, both overtly tell traders these products are daily instruments and that the funds cannot be counted on to continue delivering their stated objective over long holding periods.
“These leveraged ETFs seek a return that is 300% or -300% of the return of their benchmark index for a single day. The funds should not be expected to provide three times or negative three times the return of the benchmark’s cumulative return for periods greater than a day,” according to Direxion.
The history of leveraged ETFs is littered with examples of an index doing going up (or down) for several months and the corresponding leveraged ETF producing opposite returns. If the potential for that type gut-wrenching disappointment is not enough dissuade traders from not turning leveraged ETFs into long-term investments, maybe costs will be.
Broadly speaking, ETFs are inexpensive vehicles. Leveraged ETFs are not. In fact, expense ratios for leveraged ETFs often reside around 0.95%, 1% or more per year.
For traders that understand the costs and risks associated with these geared funds, the following leveraged ETFs could be compelling short-term opportunities.
ProShares Ultra QQQ (QLD)
Expense ratio: 0.95% per year, or $95 on a $10,000 investment.
The ProShares Ultra QQQ (NYSEARCA:QLD) is a double-leveraged bet on the aforementioned Nasdaq-100 Index. So if the Nasdaq-100 jumps 1% on a particular day, this leveraged ETF should rise by 2%.
“Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period,” according to ProShares. “These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks.”
Aggressive traders that are bullish on the likes of Apple (NASDAQ:AAPL), Amazon.com Inc.(NASDAQ:AMZN)and Microsoft (NASDAQ:MSFT), among others, can deploy QLD because those stocks represent significant percentages of the Nasdaq-100 Index.
Direxion Daily MSCI Brazil Bull 3X Shares (BRZU)
Expense ratio: 1.29% per year, or $129 on a $10,000 investment.
Traders adhering to the “daily” aspect of leveraged ETFs can use that discipline to their advantage by using leveraged to trade short-term events, such as earnings releases and geopolitical affairs. Over the near-term, the Direxion Daily MSCI Brazil Bull 3X Shares (NYSEARCA:BRZU) fits the bill as a geopolitical trade.
Brazil, Latin America’s largest economy, holds the first round of its presidential election in early October. The country, which is already one of the most volatile emerging markets without employing leverage, has a lengthy history, some recent of political volatility.
With no candidate likely to garner enough votes to avoid a run-off election, BRZU could be a rewarding leveraged ETF if markets like at least one of the two candidates that emerge from the first round election.
Direxion Daily Aerospace & Defense Bull 3X Shares (DFEN)
Expense ratio: 1% per year, or $100 on a $10,000 investment.
The Direxion Daily Aerospace & Defense Bull 3X Shares (NYSEARCA:DFEN) is the first leveraged ETF dedicated to aerospace and defense stocks. This leveraged ETF attempts to deliver triple the daily returns of the Dow Jones U.S. Select Aerospace & Defense Index.
For short-term traders, there is a lot to like with DFEN. Although this leveraged ETF is not yet a year and a half old, it has already displayed utility as a short-term play on earnings reports, geopolitical dust ups and defense spending news from Capitol Hill.
ProShares Ultra Russell2000 (UWM)
Expense ratio: 0.95% per year, or $95 on a $10,000 investment.
If the potential for volatility and out-performance with traditional small-cap ETFs is not enough, there are several leveraged ETFs providing exposure to smaller U.S. stocks. The ProShares Ultra Russell2000 (NYSEARCA:UWM)is a double-leveraged play on the widely followed Russell 2000 Index, meaning that if that index rises 1% on a particular day, this leveraged ETF should jump by 2%.
When a leveraged ETF tracks an index as diverse as the Russell 2000, stock-specific news is rarely enough to boost the fund’s fortunes. Rather, a leveraged ETF like UWM is appropriate for aggressive traders at a time when investors’ are enthusiastic about smaller stocks. That is currently the case, explaining UWM’s third-quarter gain of more than 4%.
Direxion Daily S&P Biotech Bull 3X Shares (LABU)
Expense ratio: 1.08% per year, or $108 on a $10,000 investment.
Without involving leverage, the biotechnology sector is exciting and offers the potential for rapid, short-term gains. The Direxion Daily S&P Biotech Bull 3X Shares (NYSEARCA:LABU) can ratchet those prospects up a few notches.
LABU is not the oldest leveraged ETF in the biotechnology sphere, but it has easily become a favorite of traders over the past three and a half years. This leveraged ETF looks to deliver triple the daily returns of the S&P Biotechnology Select Industry Index, a benchmark with a history of seeing its mostly mid- and small-cap holdings deliver astounding intraday performances.
Biotechnology is one of the ideal market segments for using leveraged ETFs like LABU. This sector is often move by short-term news, such as trial headlines and mergers and acquisitions news, making leveraged ETFs ideal vehicles for aggressive biotechnology traders.
Todd Shriber does not own any of the aforementioned securities.