Ultra ETF: What It Means, Benefits, Limitations

What Is an Ultra ETF?

An ultra ETF is a class of exchange-traded fund (ETF) that employs leverage in an effort to amplify the return of a set benchmark. Since first arriving on the scene in 2006, ultra ETFs have grown to include different ETFs with underlying benchmarks ranging from broad market indexes, such as the S&P 500 and Russell 2000, to specific sectors, such as technology, healthcare, and basic materials. Ultra ETFs are also known as leveraged ETFs or geared funds.

Understanding an Ultra ETF

ETFs are funds that invest in a basket of securities from the index that they track. They generally aim to achieve the same returns as their benchmark by replicating its holdings, offering investors the opportunity to mimic the performance of the broader equity market or, in other cases, gain complete exposure to a specific sector or trend.

A traditional exchange-traded fund usually tracks the securities in its underlying index on a one-to-one basis, meaning that if, for example, the S&P moves 1 percent, an S&P ETF will also move by 1 percent. Alternative ones, often referred to as ultra ETFs, seek to be more aggressive. These marketable securities use financial derivatives and debt to amplify returns, offering to double, triple, or more the long or short performance of a given underlying index.

Increased daily volatility is both the biggest benefit and greatest danger of ultra ETFs. They are best suited to short-term investing strategies or quick trading to maximize a given bet in the market—due to the high-risk, high-cost structure of ultra ETFs, they are rarely used as long-term investments.

According to the prospectuses for these funds, ultra ETFs may not achieve double or more the return of the benchmark during flat markets. Long-term returns may also diverge from the desired performance target. The ultra ETFs' only aim is to amplify the daily return—a goal they have succeeded in fairly accurately in the short time they can be analyzed.

How Ultra ETFs Achieve Leverage

Ultra ETFs can achieve leverage in a few different ways. The strategies below are meant to amplify the potential returns of the underlying index or asset class.

• Use of Derivatives Contracts: Ultra ETFs use financial derivatives such as futures contracts to gain exposure to the underlying index or asset. These derivatives provide a way to control a larger position in the underlying asset without requiring the ETF to hold the actual assets (which may be more expensive to buy outright as opposed to buying contracts for the goods).
• Use of Borrowed Capital: The ETF may also borrow money to increase its exposure. This borrowed capital is used to purchase additional assets or derivatives contracts, which, in turn, magnifies the fund's potential returns. As long as the rate of return on the good is higher than the debt service charges and fees, the net position will effectively be using leverage.
• Act of Frequent Rebalancing: To maintain the desired level of leverage, ultra ETFs usually require daily or periodic rebalancing. This means that the fund will buy or sell assets and derivatives every day to reset its leverage level to the target. This may cause more frequent fluctuations in activity which may magnify the difference between the underlying index's value and the amplified returns of the ultra ETF.
• Effect of Compounding: Due to the daily or periodic rebalancing, the returns of ultra ETFs are not a simple multiple of the underlying index's returns. Over time, the compounding effect can lead to a significant deviation from the expected multiple. For example, more frequent trading of the asset in the ETF may result in greater capital available to further invest. This compounding effect can also be a risk, as the ETF manager may need to cover loss positions more frequently to ensure adequate margins are maintained.

Benefits of an Ultra ETF

If an investor is convinced that the S&P 500 is about to rise, they will probably want to explore ways to make as much money as possible from this conviction. An ultra ETF can cater to those needs, without incurring the additional expenses and stress of trading on margin—a process whereby a broker lends money to customers so that they can purchase stocks or other securities with the securities held as collateral for the loan.

Ultra ETFs can be beneficial to tactical investors who are short on capital or allocation space within a diversified portfolio. For instance, they can invest 5 percent of their portfolios into an ultra ETF and gain closer to 10 percent exposure due to the leveraged returns.

Limitations of an Ultra ETF

Leverage is a double-edged sword: It can lead to significant gains, as well as significant losses. The use of leverage magnifies not only the return potential of these ETFs, but also the standard deviation, making these investments riskier than non-leveraged ETFs targeting the same index or investment style. In other words, these vehicles are not for the average investor.

Anyone looking to make long-term, buy and hold investments should also steer clear of ultra ETFs. Daily rebalancing and compounding, combined with leverage, will cause investment results to diverge significantly over time from expectations. This is due to the wide variance of performance that make standard performance measures such as the geometric mean of limited use.

Potential payoffs can be significantly impaired by charges, too. Because of their complexity and use of borrowed funds, ultra ETFs carry much higher expense ratios than standard ETFs. The average fee for regular ETFs is roughly 0.5 percent, or $5.00 for every $1,000 invested in 2023. Ultra ETFs, on the other hand, usually come with expense ratios of 1% or more.

Special Considerations

Ultra ETFs also enable investors to amplify their returns when shorting, or betting against, an underlying index. Inverse ultra ETFs, or ultra shorts, use leverage to make extra money when a market declines in value. When used properly, they allow sophisticated investors to hedge existing long positions with short exposure.

There are potentially greater tax implications to consider when investing in ultra ETFs. Ultra ETFs buy and sell their underlying securities more frequently, so when the fund realizes capital gains, they may be passed onto shareholders as capital gain distributions. Should these arise due to rebalancing, this may create short-term capital gains.

It is important to understand that ultra ETFs may be able to be held in tax-advantaged accounts such as IRAs. However, be mindful that these ETFs often have higher volatility and risk. If you lose your capital from investing in an ultra ETF, it may not be possible to recapture that tax-advantage benefit (i.e. you're limited in what you can contribute to your IRA each year).

The Bottom Line

Ultra ETFs, also known as leveraged ETFs, are specialized exchange-traded funds designed to provide amplified exposure to an underlying index or asset class. They achieve this leverage through the use of financial derivatives, allowing them to aim for double or triple the daily returns of the underlying benchmark. Note that ultra ETFs are generally more suitable for short-term investments and most often not deployed in long-term hold strategies.