Folklore is full of tales about adventurous people like Sindbad, the Sailor who did something that could be extraordinarily dangerous or extremely rewarding. He put his keen awareness and knowledge of his surroundings to plan his maritime journeys despite the significant risks he knew could come his way. But he was also aware of the potentially great rewards.
This is also a perfect way to describe a niche set of financial traders who trade in leveraged exchange-traded funds. Known as 3x ETF, triple leveraged ETF, these ETFs can provide three times or 3x the daily or monthly performance of the index it tracks.
It is the inherent risk of trading in such ETFs, which makes us compare these traders to nothing less than an ambitious Sindbad.
What is a 3x ETF?
Let’s take a brief look at what an ETF means to understand what a 3x ETF means.
An exchange-traded fund or ETF is a basket of securities such as stocks, that tracks an underlying index. For example, a NIFTY 50 ETF consists of stocks from the 50 companies listed on the NIFTY index. The performance of the ETF will closely resemble the performance of the NIFTY index. Just like individual stocks, the stocks of the ETF are also listed on the exchange and can be traded in throughout the trading day.
So, what does a 3x ETF mean? As you may have guessed, a 3x ETF will give the investor three times the performance of the index it tracks. This means that if the index gains 1 point, the 3x ETF holder will gain 3 points. Naturally, the same applies for a loss. If the index loses 1 point, then the 3x ETF holder incurs a 3x loss.
Typically, the trader will trade in 3x bull ETFs which means that they are counting on the growth of the market to increase their profits.
3x ETFs come with a higher expense ratio compared to traditional ETFs. So, remember that a significant part of your returns will be taken as a fee by the fund manager.
How does a 3x ETF work?
You may now be thinking about how a 3x ETF amplifies its performance. To get a 3x performance, the ETF invests in more than equities. It invests in futures contracts, options, forward contracts, swap agreements, reverse repurchase agreements, equity caps and such complex financial instruments.
Now, let’s take a simple example to see how the performance of the index that the 3x ETF is tracking affects the ETF’s returns.
Say Mr XYZ has placed Rs. 100 in a 3x ETF. What happens when the price of the index goes up 5 percent one day and down 5 percent on the next trading day? The 3x leveraged fund goes up 15 percent (since it is three times whatever is the direction of the change) and down 15 percent on the consecutive days. At the end of the first trading day, the initial Rs.100 investment is worth Rs. 115. At the end of the second trading day, the initial investment is now valued at Rs.97.75. This means there was a loss of 2.25 percent on the investment.
It is this feature of compounding loss that compels traders to buy and sell in the short-term. 3x ETFs are typically held for only a day or week to decrease the risk of compounding losses which can result in the trader/ investor losing all their principal investment.
For whom is a 3x ETF suitable?
You may have concluded for yourself that 3x ETF is not ideal for those looking to invest in low-risk, long-term securities and trying to build their retirement fund. However, someone with the following characteristics can consider a 3x ETF as part of their trading strategy:
1. Is market savvy; knows how the market works
2. Has the time and energy to actively manage their investment
3. Can take a loss
4. Understand short-term trading
Essentially, 3x ETF should be considered by someone who has extensive knowledge and understanding of the financial markets; has relatively expendable funds; the strength to take a potential hit.
Now you understand why the analogy between Sindbad and an individual trading in 3x ETFs is fair?
By now, you know that investing in 3x ETFs is only for those who have a high-risk appetite. So, if you believe that 3x ETFs have a place in your investment portfolio, head to Angel Broking, one of India’s leading brokerage houses for professional guidance.