Exchange-traded funds (ETFs) are slowly gaining popularity in India, especially among investors who are looking to explore newer avenues for portfolio diversification. An ETF is similar to an index fund since it replicates an index. The key difference between the two is that an ETF is a closed ended fund, whereas an index fund is open-ended. Investors cannot make fresh redemptions or investments when an ETF is closed. ETFs are listed on stock exchanges and these can be bought and sold just like any stock/equity. However, ETFs can be bought only if there is a seller in the market and the same goes for selling these. One of the varieties of ETFs are leveraged ETFs.
Here, we will explain more about Leveraged or Inverse funds to help new investors get a basic understanding of these.
What is an Inverse /Leveraged fund?
As the name suggests, leveraged funds are mutual funds that make use of financial leverage techniques for achieving maximum returns on investments. Some of the financial leverage techniques used are option trading, buying assets on margin, short selling, etc. These funds aim to deliver in line with the benchmark/ index that they track. Leveraged funds also make use of derivatives such as futures, options and swaps for further enhancing their performance.
How do leveraged funds work?
A leveraged exchange-traded fund (ETF) uses financial derivatives and debt to achieve returns in line with an underlying index. Leveraged ETFs are globally available on many indexes, such as the NASDAQ 100, S&P 500, etc. These funds maintain a constant amount of leverage within the investment time frame, such as a 2:1 or 3:1 ratio. Hence, if an investor has a leverage to the tune of 3:1, then the profits could be three-times with the same amount of capital. On the other hand, there could even be losses that are three-times.
Leveraged funds often involve higher operating expenses when compared to other mutual funds, and therefore the expense ratio may range anywhere between 3-5%.
Benefits of investing in leveraged mutual funds
Some of the primary benefits of Leveraged funds have been listed below:
- Tracking of the index – Leveraged mutual funds track the underlying benchmark, and this allows investors to plan their investment strategy as per the available data on the index instead of relying on the mutual fund performance alone. This also helps to check the risk exposure of an investor’s portfolio.
- Diversification – With leveraged mutual funds, investors can access a diversified and well-managed portfolio with exposure to capital markets. Investment in capital markets is generally challenging for new investors who wish to invest using a small amount. A diversified portfolio also keeps volatility in check while improving the potential to generate higher risk-adjusted returns.
What investors must know before investing in Leveraged ETFs
A leveraged ETF can cost higher as compared to an index fund that generally has an expense ratio of 0.5% on average. A leveraged ETF is actively managed and involves a considerable amount of research and professional insight. Therefore, a fund manager may charge a higher management fee that is often thrice the expense ratio of an unleveraged ETF. This can lower the returns that an investor can make out of these funds.
Just like leveraged funds can amplify returns, investors must be prepared for losses to be multiplied on investments in such funds. If the index loses 1 point, the leveraged ETF could lose up to 3 points. All these factors must be carefully considered before investing in a Leveraged ETF.
Investors must carefully weigh their risk appetite before investing in leveraged funds. It is advisable for new investors to first gain sufficient market experience before considering leveraged fund investments.
- What are leveraged funds?
A leveraged mutual fund uses financial derivatives and debt to generate higher returns on investment. While exchange-traded funds generally track the securities in the underlying index on a one-to-one basis, a leveraged fund aims for a 2:1 or 3:1 ratio to amplify returns.
- Is it good to buy a leveraged ETF?
Leveraged ETFs are ideal for investors who have a higher risk-taking ability and strong knowledge of the capital markets, especially functioning of derivatives. These can help in amplifying returns through techniques such as short selling, derivatives trading, etc.
- Are there leveraged mutual funds in India?
Currently, leveraged mutual funds are not permitted to operate in India.
- Should I invest in leveraged mutual funds?
Purchasing a leveraged mutual fund is ideal for those investors who fully understand all the risks associated with these. These are not suited for new investors since they require a basic understanding of capital markets and also derivative instruments.
- Do leveraged mutual funds pay dividends?
Leveraged or inverse ETFs may pay dividends, depending on the fund’s performance. However, these do not pay dividends as per the dividends of stocks forming the underlying index.