Exchange-traded funds (ETFs) are a collection of securities and instruments bought or sold through a broker on a stock exchange. ETFs pool investments containing stocks, bonds, mutual funds, commodities, or a mixture of all, allowing for diversification and simplifying trading. Leveraged ETFs are underlying holdings using debt, derivatives, and shareholders' equity and are designed to deliver more returns than the returns garnered from regular ETFs. Basically, leveraged ETFs use various instruments like derivatives and debt to multiply the proceeds of an underlying index. Like leveraged ETFs, traditional ETFs are also traded on stocks on an index. Traditional ETFs do this by tracking securities in their underlying index.
Why Leveraged ETFs?
How do leveraged ETFs work? Instead of having a collection of stocks that depict the performance of an index, leveraged ETFs work by using derivatives to amplify the returns of an underlying index they track. They buy futures contracts for a double or triple gain of the move of the underlying index. Various investor needs inspired the creation of leveraged ETFs; the need for stabilized pricing, open-ended trading, and something simple to use.
Stabilized pricing emanates from rebalancing effects where the positive and negative pressure from the purchase and sale of stocks cancels the effects of prices increasing or decreasing. Leveraged ETFs were also inspired by investors' needs for open-ended trading, allowing investors to experience flexibility regarding when and how to purchase shares. Investors also needed something simple to use hence the establishment of leveraged ETFs. They are simple to use because they provide economies of scale to investors through the spread of costs to many investors.
