Leveraged ETFs in Canada

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Low CommissionsWide Variety of Investment ChoicesIn-Depth Research

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A Leveraged Exchange-Traded Fund (ETF) is a type of ETF that uses financial derivatives and debt to amplify the returns of an underlying index or asset. Unlike traditional ETFs that track an index on a 1:1 basis, leveraged ETFs seek to deliver 2x (double) or 3x (triple) the daily returns of the index they track.

Leveraged ETFs can be powerful tools but come with significant risks. They are not suitable for long-term investing but can be effective for short-term trading strategies. Understanding daily rebalancing and volatility decay is essential before trading them.

For example:

• A 2x leveraged S&P 500 ETF aims to return twice the daily percentage change of the S&P 500.
• A 3x leveraged Nasdaq-100 ETF seeks to return three times the daily percentage change of the Nasdaq-100.

If the index rises by 1% in a day:

• A 2x ETF should rise by 2%.
• A 3x ETF should rise by 3%.

Similarly, if the index falls by 1%, a 2x ETF would fall by 2%, and a 3x ETF would fall by 3%.

To achieve the leveraged exposure, these ETFs use financial instruments such as:

1. Derivatives – Options, futures, or swaps help magnify exposure.
2. Borrowing (Leverage) – They may take on debt to buy more assets.

And perform Daily Rebalancing – To maintain the leverage ratio, they reset their exposure at the end of each trading day.

Because of daily rebalancing, compounding effects can cause deviations from expected returns over longer periods.

Consider a 2x leveraged ETF tracking an index over two days:

• Day 1: The index rises by 5%, so the 2x ETF gains 10%.
• Day 2: The index falls by 5%, so the ETF loses 10% of its new value (not the original).
• Over this period, the index changed by a multiple of 1.05*0.95=0.9975, while the ETF changed by a multiple of 1.1*0.9=0.99. So, while the underlying index declined by 0.25%, the 2x leveraged ETF declined by 1%.

Effectively, a leveraged ETF buys high and sells low. This can lead to a long-term divergence from simple multiplication of index return by the multiple.

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1. Potential for Higher Returns – If the market moves in your favour, returns are magnified.
2. Short-Term Trading Opportunities – Useful for day traders and momentum traders.
3. Convenience – Unlike margin accounts, investors don’t need to borrow money themselves to get leverage.

Specially for tax sheltered accounts like RRSP, TFSA and RESP which are not able to borrow money or securities leveraged ETFs are among very few ways to amplify returns.

1. Compounding Risk – Due to daily rebalancing, performance over weeks/months may diverge significantly from the expected return.
2. Volatility Decay – High volatility can erode returns even if the index ends up unchanged.
3. Higher Expense Ratios – These funds have higher fees due to complex structures.
4. Not for Long-Term Investors – Most leveraged ETFs are meant for short-term holding, not buy-and-hold strategies.

• SPXL (Direxion Daily S&P 500 Bull 3X) – Seeks 3x the daily return of the S&P 500.
• TQQQ (ProShares UltraPro QQQ) – Seeks 3x the daily return of the Nasdaq-100.
• UVXY (ProShares Ultra VIX Short-Term Futures) – Seeks 1.5x the daily return of the VIX volatility index.

Some leveraged ETFs are inverse ETFs, meaning they gain when the market falls:

• SQQQ (ProShares UltraPro Short QQQ) – Seeks 3x inverse of the Nasdaq-100.
• SPXS (Direxion Daily S&P 500 Bear 3X) – Seeks 3x inverse of the S&P 500.

• Day Traders & Active Traders – Best for those who monitor positions closely.
• Short-Term Speculators – Want to capitalize on market moves quickly.
• Hedgers – Can use inverse leveraged ETFs to hedge market declines.

• Long-Term Investors – Not suitable due to compounding decay.
• Risk-Averse Investors – Leverage increases the risk significantly.

Canadian leveraged ETFs have some unique characteristics compared to their U.S. counterparts. Canadian leveraged ETFs are useful trading tools but should be used cautiously. They provide a way to amplify gains (or hedge losses), but daily resets and compounding make them unsuitable for long-term investing. If you’re considering a leveraged ETF, make sure you understand its risks, fees, and volatility before trading. Here’s what you need to know:

Canadian leveraged ETFs aim to provide 2x or -2x (inverse) daily returns of an underlying index like the S&P TSX Index, typically using derivatives like swaps or futures contracts. Unlike in the U.S., 3x leveraged ETFs are not available in Canada due to regulatory restrictions.

• Bullish leveraged ETFs (2x exposure) amplify gains (and losses) when the market moves up (or down).
• Inverse leveraged ETFs (-2x exposure) provide double the opposite movement of the index, meaning they rise when the market falls.

Here are some well-known leveraged ETFs traded on the Toronto Stock Exchange (TSX):

Example: HQU (Global X BetaPro Nasdaq-100 2x ETF)

• If the Nasdaq-100 index rises 1% in a day, HQU is expected to rise 2% on that day (before fees and tracking error).
• If the Nasdaq-100 falls 1%, HQU is expected to lose 2%.

Example: HQD (Global X BetaPro Nasdaq-100 -2x ETF)

• If the Nasdaq-100 falls 1% in a day, HQD is expected to rise 2% on that day.
• If the Nasdaq-100 rises 1%, HQD is expected to lose 2%.

A. No U.S. Withholding Taxes

• Canadian leveraged ETFs avoid U.S. withholding taxes on dividends and interest, making them more tax-efficient for Canadian investors than U.S.-listed leveraged ETFs.

B. No 3x Leveraged ETFs

• Unlike in the U.S. (where for example TQQQ and SPXL provide 3x exposure), Canadian regulations limit leverage to 2x for both bullish and inverse ETFs.

C. Derivative-Based Exposure

• Most Canadian leveraged ETFs use total return swaps instead of directly buying stocks, helping them achieve leverage without margin debt.
• This structure minimizes tracking error but exposes investors to counterparty risk (i.e. if the swap provider fails).

D. Daily Rebalancing & Compounding Effects

• These ETFs reset daily, meaning long-term returns do not match simple multiplication (of leverage by index return) due to compounding.
• In volatile markets, returns can decay over time, even if the index remains unchanged.

Example of Volatility Decay

Even though the index rose 2.74% over three days, the leveraged ETF gained only 4.94% (compared with 2*2.74%=5.48%), showing how compounding affects returns over time.

A. Not for Long-Term Holding

• Due to daily resets and compounding, holding these ETFs for long periods erodes returns.
• Best suited for short-term traders and hedging rather than long-term investments.

B. High Volatility = High Risk

• Leveraged ETFs are extremely volatile, making them risky.
• During sharp market drops, leveraged ETFs can lose value quickly.

C. Counterparty & Liquidity Risk

• Since most Canadian leveraged ETFs use swaps, there's a risk if the counterparty (usually a major bank) defaults.
• Some ETFs have low trading volume, leading to wider bid-ask spreads.

• ✅ Short-Term Trading – Best for traders looking to capitalize on short-term market moves.
• ✅ Hedging – Investors can use inverse leveraged ETFs to hedge portfolios.
• ✅ Intraday Trading – Ideal for day traders who monitor markets closely.

• 🚫 Not for Long-Term Holding – Due to volatility decay and compounding effects.
• 🚫 Not for Conservative Investors – These ETFs are highly speculative.