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What are Leveraged ETFs?

Leveraged ETFs are exchange-traded funds that employ leverage strategies including options, futures, and short sales to amplify potential investment gains. Do they belong in your portfolio?

ETF's appeal to investors looking for diversification; for advanced investors, leveraged ETFs can amplify gains or losses.Exchange-traded funds (ETFs) are a popular investment vehicle for experienced and beginning investors alike. ETFs appeal to people looking for diversification, who want the ability to trade them like stocks but also want at least some level of professional management.

Leveraged ETFs invest in options, futures, and even currencies in an attempt to amplify the potential gains. This, of course, means leveraged ETFs can also amplify losses.

Why ETFs?

Although ETFs are not actively managed like mutual funds, ETFs still have a passive type of control in which stocks are chosen and grouped together to follow a theme. ETFs operate by mimicking an index such as the S&P 500, a sector such as health care, or a commodity such as gold.

Since the proliferation of ETFs, Wall Street has taken to redesigning these instruments to include riskier and more volatile trading methods to appeal to more aggressive investors.

What is a leveraged ETF?

A new class of ETFs use leverage by investing in options, futures and foreign currencies to amplify both gains and losses. Leveraged ETFs don’t just stick with positive movements and may employ derivatives to short a position, thus providing investors the ability to profit from bear markets. In symphony, these tactics give hedge fund-like abilities to the everyday trader.

That sounds cool — but are leveraged ETFs right for long-term investors or are they another risky product best left to the professionals and the gamblers?

Examples of leveraged ETFs

Investors looking to bolster gains without delving into options and futures directly may benefit from leveraged ETFs. Let’s take gold as an example.

Gold is a popular commodity and trades with high volume every day in the market. Unfortunately, unless you have sophisticated knowledge of futures contracts and at least $50,000 you’re willing to devote to just to gold, you might have a hard time investing in it.

Luckily, you have access to ETFs like SPDR Gold Shares (GLD), one of the most popular funds available. But let’s say you want to take advantage of how far the price of gold has fallen and you’re willing to double down and can easily absorb any losses you might sustain. Then you could look to ProShares Ultra Gold (UGL), an ETF that aims to mimic the gold index by a factor of two. For the extremely bold, there’s an option to increase it even more with VelocityShares 3x Gold (UGLD) which — as the name suggests — amplifies gains or losses by a multiple of three.

Let’s assume you have no interest in 2x or 3x ETFs; you just want to protect yourself from bear markets. Within the umbrella of leveraged ETFs lie inverse funds. This type of ETF establishes a short position and will profit when the underlying security drops in value.

If you’re just looking for a little insurance, you might consider something like ProShares Short Dow30 (DOG) which shorts the Dow Jones. If you’re more of a tactical asset allocator, you may be interested in inverse sector ETFs like ProShares Short Financials (SEF). These products allow you to access the higher realm of institutional investors by strategically buying long on stocks and sectors you think will do well and shorting those you think will get left behind.

Where to learn more

While ETFs encompass thousands of investments, many of which are well-suited to beginning investors, using leveraged ETFs in your portfolio is an advanced strategy.

The ETF Database is a good place to begin researching your various options. Although it’s far from a comprehensive site, it should at least give you an idea of what options are available. Keep in mind that financial leverage is not for the faint of heart due to the extreme volatility that often accompanies this strategy. You should use extreme caution when including these financial instruments in your portfolio.

About Daniel Cross

Daniel Cross has been in the industry as an investment writer and financial advisor since 2005. He holds the Chartered Financial Consultant designation (ChFC) as well as Series 7 and Series 66 licenses, and has embarked on the arduous journey of obtaining the coveted CFA designation. Daniel lives in Florida with his wife, daughter, and pet Tortoise ironically named Turbo.