Definition
A leveraged ETF is an exchange-traded fund designed to follow 2 or 3 times the daily move of a particular stock index. It can earn bigger gains when prices rise, but losses also grow several times larger when prices fall, which makes it a high-risk product.
A Fund Running With a Lever Attached
Like a seesaw or a lever on a playground, a tool that lets a small force lift a heavy load is called leverage in finance. A regular index fund rises 1% when an index like the KOSPI or the Nasdaq rises 1%. A 2x leveraged ETF is designed to amplify the daily move by 2 times, so it rises 2%.
On the flip side, if the index falls 1%, the loss in your account is also doubled to 2%. When you call a market's rise exactly right, you can earn far more in a short time than other investors, which looks very attractive to many people.
But this flashy multiplier is never free. Behind the dream of growing your money twice as fast as everyone else, there is always a partner: the risk of your principal melting away twice as fast.
Why Your Account Melts in a Sideways Market
Many people assume, "If the market goes up and down and ends up right where it started, my money will be right where it started too, right?" But a leveraged ETF uses daily compounding, multiplying each day's move by the leverage factor, and that leads to something strange.
For example, say an index starts at 1,000,000 won and rises 10% on the first day, then falls 10% the next day. You end up with 990,000 won. A 2x leveraged product rises 20% on day one to 1,200,000 won, then falls 20% (240,000 won) the next day and shrinks to 960,000 won.
The index lost just 1%, but the leveraged product lost 4%. Even when prices only swing up and down with no clear uptrend, your account can get chipped away bit by bit. This is called volatility decay.
More Precisely: Why Holding Long Term Is Risky
To be more precise, the prospectus of most leveraged ETFs says the fund aims to track returns over a single day. That means if an index rises 10% over a year, a leveraged ETF is not built to deliver exactly 20%.
Of course, in a strong bull market where the index rises every single day, compounding works in your favor and can even pay off more than the 2x you expected. But real stock markets keep going up and down, creating volatility.
For this reason, regulators such as the U.S. Financial Industry Regulatory Authority (FINRA) explain that leveraged ETFs are products designed with single-day trading in mind, so holding them for a long time can lead to results very different from what you expect.
Common misconceptions
The index rose 20% over a year, so a 2x leveraged ETF will surely return 40%.
A leveraged ETF follows 2 times the daily move. Over a year, the total return depends on the path prices take up and down. If prices rise steadily, you might get more than 40%. But if they swing a lot, volatility decay can leave you far below 40%, or even with a loss.
Where you meet it
TQQQ, which follows 3 times the daily move of the Nasdaq-100, and Korea's "KODEX Leverage" fund, which follows 2 times the KOSPI 200, are well-known examples.
Even if prices stay trapped in a range and only bounce up and down for months, money in a leveraged ETF tends to shrink slowly because of negative compounding.
In one sentence
It aims for profit by multiplying the daily move several times, but when prices move sideways, compounding can melt your principal. It is a fund designed with single-day trading in mind.