leveraged (2x, 3x) index funds. How do they work?
In: Economics
with a normal index fund there will be some kind of holding organizations that will in most cases physically buy the stocks that are in the index fund and therefor they get a 1:1 representation of what the market movements are.
For leveraged index funds this is not possible, these funds instead buy derivatives, these are contracts between different participants on the financial markets.
what they will essentially do is go to some bank or other financial institution and create a contract thats essentially betting on movements of the stocks that are in the index fund instead of actually buying them.
these contracts can say virtually anything, you could make it 1000 times leveraged if you wanted to but that of course comes with significant risk and also some cost.
in the end nobody is buying or selling anything, they are all just saying “Lets pretend we did and then do the math on what would have happened”
the entire derivative market is a huge game of “lets pretend”
You basically borrow stocks or money to trade with. Let’s say that you have enough money to buy 10 stocks which you expect to go up. With 2x leverage you’re borrowing the money for the remaining 10, which means your profits will go up twice as fast if the stock goes up.
Seeing a lot of comments here either getting the details wrong or omitting them. More often than not the fund enters into a contract called a Total Return Swap (TRS) with a bank’s prime brokerage division. The TRS gives the fund exposure to $X notional of some underlying asset. In return, the fund pays Y% interest on that notional exposure, to compensate the bank for A) The bank’s funding costs for buying the underlying asset and holding it on their balance sheet, and B) A (usually smallish) profit margin. X can be basically any amount, but the prime brokerage will usually have some additional margin requirements that scale with notional exposure so that, for a move in the underlying consistent with its historical volatility, adjusted for the credit quality of the fund, there will be enough money sitting in the margin account to make sure the bank gets paid if the position moves against the fund.
This sometimes doesn’t work out, and that’s how Credit Suisse lost a billion dollars when Archegos failed.
Example for a 2x leverage fund.
You start with $100 from investors. Instead of buying $100 worth of stocks, you borrow another $100 and buy $200 worth of stocks.
As the investor you are 2x leveraged as for every $1 you put in, you have $2 worth of exposure to the underlying stocks in the fund.
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