What Is a Leveraged ETF?

A leveraged ETF (exchanged-traded fund) is like most ETFs in that it trades like a stock and is designed to track the performance of a particular index. However, a leveraged ETF is distinctly different in two ways.

A leveraged ETF uses financial derivatives and debt to increase returns. It also doesn't track the returns of an index on an annual basis, but the daily changes.

Here's a closer look.

How a Leveraged ETF Operates

Magnified Exposure to an Index: Classic ETFs track an index or a basket in a one-for-one manner and are basically passively managed. Leveraged ETFs, meanwhile, attempt to track an index or basket in a two-for-one or three-for-one manner. They require active management.

In short, leveraged ETFs exaggerate the impact of markets' movements. As such, their price will be much more volatile (two or three times) than the underlying index.

In a leveraged ETF with a 2:1 ratio, for example, each dollar of investor capital is matched with an additional dollar. On any given day the underlying index returns 1%, the fund will ideally return 2%. That 2% return will be slightly less for leveraged ETF investors due to management fees and transactions costs.

That kind of return is great when an index is rising. But leveraged ETFs work both ways. When an index falls, a loss in a leveraged ETF will be magnified. A 1% drop in an index translates into a 2% drop in a leveraged ETFs.

Focused on Daily Performance: Most leveraged ETFs are designed to hit their goal every day. That means their performance over long periods of time ends up differing from the underlying index.

The following example from the Securities and Exchange Commission's (SEC) website is a prime illustration: