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A leveraged exchange-traded fund, or simply leveraged ETF, is a special type of ETF that attempts to achieve returns that are more sensitive to market movements than a non-leveraged ETF. Leveraged index ETFs are often marketed as bull or bear funds. A leveraged bull ETF fund might for example attempt to achieve daily returns that are 2x or 3x more pronounced than the Dow Jones Industrial Average or the S&P 500 negating the need to apply margin. Applying margin to a 2x Performance ETF would result in being leveraged on a position by 400%. Likewise on a 3x Performance ETF, that amount would increase to 600%. Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return. The most common way to construct leveraged ETFs is by trading future contracts.
The rebalancing of leveraged ETFs may have considerable costs when markets are volatile. The problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. A 2.5% daily change in the index will for example reduce value of a -2x bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year. Investors may however circumvent this problem by buying futures directly, accepting a varying leverage ratio.
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