What are Exchange Traded Funds (ETFs) & Leveraged ETFs?

 

What are Exchange Traded Funds?

Brief History of ETF

Types of ETFs available in market

What do you mean by Leverage?

How do you identify leveraged ETFs?

1. Meaning:

ETF is a hybrid instrument that combines the feature of index mutual funds and stock. It is also called index shares. The funds are listed on the stock exchange and their prices are linked to the underlying index. The authorized participants act as the market makers for ETFs.

ETFs are tradable in any listed stock exchange like any other listed security. Their trading price is more or less closer to the NAV at the end of the day. NAV comprises the value of the underlying component of the benchmark index held by ETF plus all accrued dividends less accrued management fees.

 

ETF involves less paperwork and it can be simply bought by placing an order with a broker. In addition, it involves low-cost diversification, trading arbitrage opportunities, and tax efficiency.

2. Brief History of ETF

The ETF was first introduced in Canada in 1990. At first, only institutional investors used to invest in ETFs to execute their trading strategies. Later individual investors and financial advisors began to embrace it because of its low-cost diversification and arbitrage possibilities. Exchange-traded funds were introduced in the US in 1993 and came to India in 2002.

 

3. Types of ETFs available in market

Following are some of the types of ETFs available in the market:

• Index ETFs: Invest in the securities of companies and the value of the index ETF moves in tandem with the market index.

 

• Commodity ETFs: Invest in commodities such as precious metals and futures.

 

• Bond ETFs: Invest in bonds. These types of ETFs can withstand economic recession as they involve fewer risks.

 

• Currency ETFs: Invest in the foreign exchange where investors get access to institutional interest rates and a collateral yield.

 

• Leveraged ETFs: A leveraged ETF uses financial derivatives and debt to magnify the returns of an underlying index.

 

4. What do you mean by leverage?

Notwithstanding any other meaning of leverage, in the context of ETF, leverage is referred to as an investment strategy where the borrowed fund or financial instrument is used to amplify the potential return of an investment.

 

Investors use leverage to increase their returns on investment significantly. For this various hybrid instruments like options, futures, and margin accounts are used.

 

One of the disadvantages of leverage is that it is a double-edged sword. The investors use it to multiply the returns but its reverse is also true i.e. loss also multiplies when the condition is unfavorable.

 

5. How do you identify a leveraged ETF?

One can use the lever to multiply one's effort so that s/he can lift a stone that s/he cannot lift without the use of the lever.  Similarly, the leveraged ETF uses borrowed capital, and derivative instruments like options and futures so that the returns from investment are increased many times.

 

As we know that beta of the index is always one. The beta of traditional ETF is also one. Beta measures the risk of a security or ETF in the market. It means that when the value of the index moves up by 1%, the value of the ETF also moves up by 1% and the reverse is the case when the index moves down.

 

With the use of leverage, the risk of ETF increases, and in turn beta also increases. The level of debt determines what would be the beta of the levered ETF. Suppose with the use of debt, the beta of ETF rises to 2.5. Now, when the value of the index moves up by 2%, the value of the ETF moves up by 5%. This is the magic of leverage. But the loss also multiplies manifold when the index falls which is the disadvantage of using leverage.

 

Therefore, it is recommended for investors to be cautious when investing in leveraged ETFs because the risk is far higher than those in traditional ETFs.