When people think of ETFs, the first words that pop into their heads are likely to be “safe” or “boring.” That’s not the case, though, with so-called leveraged ETFs, which are a more recent innovation offering investors a way to double their returns when they make a bet on a stock index—or, as has been the case in the past two years, on individual stocks like Nvidia or Tesla. These products have been soaring in popularity to the point that leveraged bets on individual stocks have recently jumped 400%.
The chance to double returns through leverage may be appealing, but it’s also one that most ordinary investors may wish to avoid since, if the market moves in the opposite direction than expected, their losses will be double. Since leveraged ETFs now appear to be a permanent part of the investment landscape, it’s worth taking a closer look at how they work and who is using them.
ETFs: From safe to speculative
State Street launched the first exchange-traded fund in the U.S. in 1993. Still around to this day, the ticker known as SPY tracks the S&P 500 and offers retail investors a cheap and easy way to approximate the returns of the overall market . Today, ETFs are widely popular as a way to diversify one’s portfolio while pursuing the classic “ buy-and-hold ” strategies preached by the likes of Warren Buffett and the late Vanguard founder Jack Bogle .
Recently, however, there has been an uptick in popularity for so-called leveraged ETFs, which provide opportunities for more speculative strategies. Leveraged ETFs offer new opportunities for yield, but also introduce new risks for everyday investors as well as potential headaches for regulators.
The first leveraged ETFs arrived in 2006, 13 years after the launch of the first U.S.-listed ETFs. The product came by way of Maryland ETF giant ProShares, which issued the first leveraged and inverse versions—meaning they offered two times or negative-two times the daily returns of popular market indexes.
“When they first got launched, there was some uncertainty around the adoption,” Aniket Ullal, head of ETF research and analytics at CFRA, told Fortune, “but very quickly it became apparent that there was interest in these products.”
Eventually, leveraged ETFs spread to sectors like technology and particularly volatile industries like semiconductors. Then came so-called single-stock funds, which apply the same concept to amplify the bear or bull case on a single security. While some single-stock offerings are listed as ETFs, others are not subject to the Investment Company Act of 1940 (which applies to mutual funds and ETFs) and fall under the broader umbrella of exchange-traded products.
Despite pushback within the Securities and Exchange Commission, leveraged ETFs offering two times the returns of popular and volatile stocks like Tesla and Nvidia gained approval in the U.S. two years ago. These leveraged single-stock offerings now represent $13.4 billion in assets, according to Bloomberg Intelligence data, compared with $3.3 billion last year.
These products are also easy to purchase. First mover ProShares still manages the most heavily traded leveraged and inverse index funds, both of which track the Nasdaq. The next biggest funds in each category track the semiconductor industry and are issued by Direxion.
As these funds become increasingly popular, however, should investors steer clear?
What investors need to know about leveraged ETFs and single-stock funds
The most crucial thing to keep in mind, Ullal said, is that these products are not designed for the average buy-and-hold investor. Most leveraged and inverse ETFs, as well as single-stock funds, use debt and financial derivatives to track an index’s return daily, rather than over an extended period.
For example, if the S&P 500 increases by 1% on a specific day, a two-times leveraged ETF will return 2% (with the equivalent inverse fund doing the opposite). If the S&P increases by 10% over the course of a month, however, the leveraged ETF will not necessarily return 20%.
The reason why leveraged ETFs don’t necessarily double over time is because their returns are a function of their debt-to-equity ratios, meaning these funds must rebalance their portfolios at the end of each day and, therefore, do not provide compounding returns. In other words, if the price of the underlying index or stock increases, the leveraged fund must take on debt or buy stock to reset its leverage. The opposite applies if the value of the underlying asset drops.
So, while the S&P has gained over 20% this year, Direxion’s three-times leveraged ETF for the index has jumped 50%, not 60%, in that span. The same concept applies to single-stock funds. While Bitcoin proxy MicroStrategy is up over 260% in the past 12 months, for example, a triple-leveraged product tracking the stock from GraniteShares is down nearly 50% in the same period.
“It’s more designed for taking a directional view or a high-conviction view on a particular theme, factor, [or] sector,” Ullal said of a leveraged product, “as opposed to holding it for the long term.”
For both institutional or sophisticated retail investors, he noted, these funds are a quick, easy, and highly liquid way to make bets surrounding earnings calls, jobs reports , or other important events . The products are especially useful for retail traders who don’t want to open a new brokerage account approved for trading options and futures directly.
These funds, Ullal said, present a tradeoff to regulators like the SEC , which has tried to thread the needle between promoting product availability and mitigating the risk of misuse. When the first single-stock funds in the U.S. debuted in 2022, some SEC commissioners warned the SEC had not done enough to protect investors.
“We haven’t had huge issues,” Ullal said, “but there’s always inherent risk.”
Investors appear to be largely using the products as intended. Leveraged and inverse funds tracking the Nasdaq or semiconductor sector account for the top four ETFs by trading volume , with single-day funds for Nvidia and Tesla, as well as a three-times leveraged S&P ETF, also in the top 10.
“The ratio of the trading volume to assets is very high,” Ullal said, “so that’s always an indicator there’s more institutional adoption.”
While the exact breakdown of hedge funds to retail investors is not known, Ullal said, the data shows investors gravitate to the most leveraged forms of these products.
That’s not necessarily a bad thing, but investors need to know what they’re getting into.
This story was originally featured on Fortune.com
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