Mastering Leveraged ETFs - IBKR Podcast Ep. 393

— Hi everyone. This is Jeff Christian from Interactive Brokers. It's my pleasure to welcome back to Interactive Brokers podcast studio Will Rhimes from GraniteShares. Hey Will, how are you? — Good thanks Jeff. — Love having you come in for our monthly talk on all things about the market either it's commodities or ETFs or options or futures and today we're going to talk about a leverage ETFs. With um you know pretty interesting instrument, right? So Will it's probably best to start with the foundation. How do cuz I think a lot of people may have heard of leverage ETFs but they're not sure really what they are, how they work. So how do they achieve their daily return targets and why is that daily reset so important? — Yeah, so leverage ETFs in a nutshell uh ETFs where you have pre-packaged leverage or preset leverage on anything from an index to a single stock and these are super popular here in the United States. Typically that's two times is the leverage factor. So two times the return of an underlying stock or an underlying index over a given day. And those can be both long and short. — And how should traders think about these leverage ETFs? Like should they think about them differently than from traditional ETFs in terms of structure in terms of risk in terms of time horizon? — Yeah, so there's a few things that people should be aware of. I think the most important thing Jeff is that leverage ETFs work in the same way really regardless of whether you buy a leverage ETF from a company like us or from other folks in the market. They're based upon a daily rebalancing or a daily reset mechanism. What that means is the portfolio gets rebalanced at the end of each day, and the reason for doing that is so the leverage remains constant. In other words, if it's two times leverage, you want to make sure that it's two times leverage today, tomorrow, or in 6 months time, etc. Now, the net effect of doing that is you do get some deviation from the underlying price over time. So, in other words, let's just hypothetically say that you would to look at the price of a leveraged ETF over a 12-month period versus the price of the underlying, and it wouldn't be exactly two times. And the reason for that is because the portfolio has been or is being rebalanced on a daily basis. — And well, comp- compounding's often misunderstood. So, how does it kind of dive a little bit more into this? How does the timing of these rebalances impact returns over multiple days, especially if the markets are choppy? — Yeah, so at the risk of oversimplifying it, what the effect amounts to is in a trending market, the leveraged ETF will most likely outperform the 2x return if you'd hold held the stock itself or the underlying index. In a down market, it will most likely underperform the 2x, and then in a choppy market, it will most likely underperform again the two times metric on the underlying stock because the portfolio is constantly going up and down. So, trending markets are really the environment that these products love most. — Got you. And obviously, we're not giving any kind of trading advice out here, but who are these who's sort of like the who are these leveraged ETFs designed for? Like, are they for short-term traders, tactical allocators, or someone in between? — Yeah, I mean, I think from a first principles perspective, if you think about what these products do and the appeal of it, it just simply provides access to leverage in an ETF, and you don't have to worry about margin or traditional margin accounts. So, you think of a world where traditionally, you'd have a brokerage account, you'd have to get margin, and from a leverage perspective, if it went against you, you might end up owing the broker money or be closed out of your position prematurely. So, ETFs solve that. You don't have any margin requirements. And so, from that perspective, it's then just for anybody that want to implement or amplify exposure to could be underlying stocks, or it could be indexes. And people use them in all sorts of different ways. So, clearly, at the moment, obviously, we're just finishing up the earning season, which is probably one of our busiest times during the year. And you can imagine that you see elevated trading patterns when all these stocks are reporting earnings, and obviously, particularly ones where we have leveraged ETFs in the mix. And so, that's a super popular time of year

and we can regularly see on our platform trading volumes of above $4 billion a day in earning season. Now, I think one of the attractive things for traders, beyond the fact that you don't have margin, is that with ETFs, they allow you to participate in the pre-market and the post-market, which is different from options, for example, where you can't do that. And so, we see a lot of action, particularly from international investors, who are able to trade through overnight platforms, overnight markets, to domestic investors here that are able to place orders in the pre and post-market. And that's a very interesting sort of phenomenon we observe, particularly again around earnings times and when there's volatility in the market. — I mean, I'm glad you brought up earnings cuz, you know, earning season's always a, you know, a big time of year for, you know, four times a year, really. And volatility tends to spike and then it tends to collapse and you have this leading up to this news and then all of a sudden the news comes out. So, could you dive a little bit more into like how that environment impacts these leverage ETFs performance or behavior? — Yeah, I mean, I think what people really look for is big moves. And clearly, if you can earn two times the performance of an underlying over a given day, then you're probably more naturally drawn to markets that are volatile and where there's a lot of movement both on the long and the short side, I should say. So, this is not just about the potential for a stock or an underlying to go up. This is about being able to take advantage of a downward movement, which is also very important in volatile periods. But, I think typically, what people are looking to do is express a bullish or bearish view over a short period of time around, let's say, an earnings announcement or a big piece of market made market moving news coming out of the government or the Federal Reserve or something like that. — Got you. So, really, kind of going back to your original thing where if you have a strong directional conviction, this may be something that you want to look into. You want to kind of flip the script a little bit here, Will. And now, what are some of the bigger, I guess, I wouldn't say biggest risk, but what are some of the risks that traders may overlook when using these leverage ETFs? — Yeah, I mean, I think, well, first and foremost, the most obvious with any kind of leverage is, yes, you have, if it's a 2x long product, you have the potential for two times the return or double the return of the underlying, but you also have potential for two times the losses of the underlying as well if it goes in the wrong direction. So, just, I guess, as a first principle, anytime you're using leverage, then there's more risk involved and therefore there's more risk of losses, not just for gains. And then I think beyond that, it's really understanding the daily rebalancing, the path dependency of the ETF over time, particularly how the longer you hold the ETF, the more that return stream will potentially deviate from the two times linear return of whatever the underlying is, be a stock or an index. But I think if you understand those two principles, then a lot of then the other mechanics are really just regular ETFs risks, if you want to call them that, such as trading, best times to trade a particular underlying, if there's thinly if it's thinly traded, if it's if it trades a lot, timing considerations again where it might be more volatile over earnings, and that might maybe a time you actually don't want to participate, or maybe it's a time you do want to participate. But those are more market timing things as opposed to actually structurally with the product. — And well, I'm going to skip question eight. I don't It's probably talking about timing and trading is probably not a good idea for We don't think we need to go there. Can he Will Can these instruments be used for like risk management? Is that something that individuals may want to you utilize these for? Maybe short-term news events coming up and they have a position and they can kind of buy one of these leverage ETFs that would kind of you know, especially like in these short-term potentially high volatile windows? — And that's right. So, when you're looking at these kind of instruments, I think sometimes it's left unsaid that you can use these defensively as well as offensively. And so, if you have a short exposure on an underlying stock, you can do obviously anything from just providing pure hedging activity against the performance of the underlying to tax strategies where you're able to manufacture taxable losses against the portfolio or just be a bit more tactical because you probably a long the underlying stock or long the underlying index via ETF itself and maybe you don't

want to sell that and realize a taxable event and so maybe using either a short position or long position around that trade specific events is something that's appealing to you. — And it well, it's been great. I kind of want to end it though with a people considering these leveraged ETFs, I guess what would be the kind of the most important rule of thumb or best practice for them? — Well, I think the starting point would be for anybody thinking about these clearly more risky products than regular ETFs. In other words, unleveraged ETFs. I think the starting point would be to assess whether leveraged ETFs are a good fit for you. And so, if you're somebody that is comfortable with the risk and you're comfortable with how these products work then they can be something that's is an addition to your portfolio, to your trading activities, to your investing style and clearly the amount of interest that we have in these products is absolutely huge and therefore there's a community of users out there that absolutely love these products. But like other activities, investing related activities that are more on the risk curve such as prediction markets or cryptocurrencies, nothing is risk free in this life. And definitely, leveraged ETFs are firmly in the category of those that love or like adding more risk to the portfolio and sort of thrive in these kind of volatile environments. — Well, this has been great as always. For our listeners, you can find more from Will Rhines at granitehsres. com or on our website at interactivebrokers. com. Click on education, find great podcast, webinars, and articles. Thanks again, Will, and looking forward to next time. — Thanks, Jeff. Appreciate having me back on. Thank you. — Yep. — The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry, or sector trends, or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell, or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives, or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and as necessary, seek professional advice. Any discussion or mention of an ETF is not to be construed as recommendation, promotion, or solicitation. All investors should review and consider associated investment risks, charges, and expenses of the investment company or fund prior to investing. Before acting on this material, you should necessary, seek professional advice. Complex or leveraged exchange-traded products are complicated instruments that should only be used by sophisticated investors who fully understand the terms, investment strategy, and risks associated with the products. Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment. For additional information regarding margin loan rates, see ibkr. com/interest. Interactive Brokers does not provide tax advice, does not make representations regarding the particular tax consequences of any investments, and cannot assist clients with tax filings. Investors should consult with their tax professional about the tax implications of any investment.