Leveraged ETFs: what are they, and how do they work?

Leveraged ETFs sound almost too good to be true: all the simplicity of an ETF, but with potential returns multiplied by two or three times. 

But just like your mother told you, if something sounds too good to be true, it probably is. 

Get the timing right and leveraged ETFs can generate spectacular returns in a short space of time. Get it wrong – or simply push your luck too long – and your capital can go up in smoke just as dramatically, even in a market that's broadly going in the right direction.

We'll break down exactly how leveraged ETFs work, and why they don't behave in the way that many investors expect.

What is leverage?

Before we get into leveraged ETFs specifically, it helps to understand what leverage actually means in finance in general.

At its core, leverage just means using borrowed money to increase the size of your investment. The idea is simple: if you can amplify how much you're putting to work in the market, you can amplify your returns.

And you've probably used financial leverage in everyday life.

A mortgage is leverage – you put down a deposit and borrow the rest to control an asset worth far more than your own money alone. If the property rises in value, your gains are calculated on the full value, not just your deposit. A property appreciating in value from £300,000 to £330,000 is a 10% increase – but it would be a 100% return on your £30,000 deposit. That's leverage in action.

A business loan is leverage too. A founder borrows £50,000 to buy equipment, hire staff, and open their doors. The business generates £200,000 in revenue. Those returns are built on borrowed capital – without the loan, there's no business, no revenue, no upside. The debt was the thing that made the return possible.

Or to put it another way, leverage can be a smart financial tool.

Using leverage in investing or trading, though, is a different – and far more complicated – kettle of fish.

What are leveraged ETFs?

You're hopefully familiar with how regular ETFs work: they bundle together a collection of assets – stocks, bonds, commodities – and aim to replicate their performance as closely as possible.

A leveraged ETF, on the other hand, replicates the performance of the same underlying index, but aims to multiply daily price moved by a set amount, such as 2x or 3x. 

Unlike a normal ETF, leveraged ETFs don't normally hold the underlying securities directly. Instead, they use financial derivatives – essentially contracts with other financial institutions that are designed to mimic the performance of the index (though often less cleanly), but multiplied. 

This means that rather than owning the stocks themselves, the fund is entering into agreements that say: if this index goes up 1%, pay us 3% (and vice versa).

Think of it like placing a bet with a bookie rather than actually buying a racehorse. You don't own the horse, but you've got an agreement that pays out based on how it performs. All the thrills (and spills) of the race, none of the hay bails.

How leveraged ETFs work in practice

The US market has historically provided an annualised return of around 10% for the past 20 years. Great, you might think, why not just buy a leveraged S&P 500 ETF and triple that return?

Unfortunately, it doesn't work that way. 

With a conventional ETF, you're holding it for the long-term. You hope that markets rise over time, and day-to-day movements are pretty much an irrelevance. 

A leveraged ETF, on the other hand, rebalances daily back to its target leverage ratio. So, you're essentially making a fresh bet each morning on what the market will do that day. 

Because of that daily reset, holding an ETF for longer than a day can amplify gains – but can just as easily amplify losses. 

In a steadily rising market, each day's gains are applied to a slightly larger base than the day before, meaning returns can exceed even what the leverage ratio would suggest.

But as we all know, markets don't move in straight lines. In a volatile market – one that lurches up one day and down the next – the same compounding effect starts to work against you. 

And the more volatile the market, the more this effect accumulates over time, eroding your returns even if the underlying asset ends up roughly where it began. In fact, as the chart below shows, the market can go up, come back down, and go up again – and a leveraged ETF investor can still end up significantly behind someone who simply held the standard version.

For this very reason, leveraged ETFs (and derivatives markets in general) sit much closer to speculation – or even outright gambling – than they do to conventional investing. That is, unless you happen to know someone at the White House. 

When you invest, you don't need to be right about what happens on any given Tuesday. You just need to be roughly right about the direction of travel over many years.

With a leveraged ETF, Tuesday is everything – you are by definition making a short-term directional bet.

And to come out ahead long-term, you don't just need the market to move in your favour, you need it to do so consistently, with as little back-and-forth as possible. Volatility, which long-term investors can largely ignore (and can even sometimes be beneficial), is actively your enemy.

And even professionals making use of leveraged ETFs often come out worse on the other side – a 2021 study found that institutions that held these types of assets fared worse financially than those that didn't.

2x leveraged ETFs: a worked example

Let's say you've spent the past half hour reading apocalyptic macro threads on X and you've got a great feeling about gold. 

You invest £1,000 in a 2x leveraged ETF tracking the gold spot price, and a standard £1,000 in a conventional gold ETF.

Day one is good all round. Gold rises 10%. Your leveraged ETF returns 20%, taking your £1,000 to £1,200. Your standard ETF is sitting on £1,100.

Day two, it falls 10%. For your standard ETF, that's roughly a round trip – you drop to £990.

For your leveraged ETF, a 10% fall in gold means a 20% fall in your ETF. Your £1,200 drops to £960.

Even though gold ended up more or less where it started, you're still down £40.

But what if gold bounces back – surely a 2x leveraged ETF would recover twice as fast? It could. But the problem is that large losses are disproportionately hard to recover from, and leverage amplifies those losses just as aggressively as the gains.

A loss of 10% requires a gain of 11% to break even. A loss of 20% requires a gain of 25%. A loss of 33% requires a gain of 50%. A loss of 50% requires a gain of 100%. The hole is always deeper than it looks, and a leveraged ETF digs it twice as fast.

You might also come across "short" versions of leveraged ETFs, which do the opposite. A 2x short gold ETF, for example, aims to rise 2% for every 1% fall in gold, effectively allowing you to bet against it.

In theory, that gives you more flexibility. In practice, it comes with exactly the same problems. The daily reset still applies, the swings are still amplified, and the impact of volatility still chips away at returns over time.

How fees compare

Still sound tempting? Well, who are we to stop you from exercising your God-given free will.

But it's worth knowing that leveraged ETFs also come with higher fees attached. That daily rebalancing doesn't happen by itself – the fund is constantly buying and selling derivatives, adjusting its positions to maintain the target leverage ratio. That activity has a cost, and it's passed on to you in the form of a higher ongoing charges figure.

Where a standard ETF might charge 0.05% to 0.20% a year, leveraged ETFs commonly charge anywhere from 0.50% to 1% or more. 

Take WisdomTree’s gold fund – the regular ETF tracking the spot price of gold has a fee of just 0.12%. The 3x leveraged version, on the other hand, has a fee of 0.99%. That's around eight times higher. 

In a product where compounding and volatility are already working against you, fees are yet another headwind pulling in the same direction.

Bottom line

Leveraged ETFs are a tool built for a very specific job: making short-term, directional bets on daily market movements. In the hands of an experienced trader who knows exactly what they're doing, they have their place. For the long-term investor trying to build wealth over time, they are – at best – a distraction, and at worst, a reliable way to lose money even in a market that's broadly going up.

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