If a hypothetical stock index returns 100%, an ETF tracking the index might only return 99% because of ETF fees. This introduces tracking errors. Why don't index ETFs use leverage to offset the fees they charge, so that they could track their index more precisely? For instance, an index ETF could lever itself to 101%, with the 1% contributing to fees while the remaining 100% contributes to the precise tracking of the index. Why isn't this method used to eliminate tracking errors?

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    The only point of running an ETF fund is to generate the 1% commission, not to track the index. Tracking an index accurately doesn't matter so long you are doing OK compared with your competitors. – alephzero Sep 10 at 21:30
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    My naive answer: if it were that easy, you could just lever to 120%, or 200%, or X00%, and either pocket a lot more fees or pay out way above the benchmark ... – xLeitix Sep 11 at 7:44

Leverage can be good to increase gains, but it amplifies movements of a stock. Also downward movements. Paired with the increased gains is also an increased risk, and that changes the investment vehicle. The goal of an index fund is to passively follow an index as closely as possible. Leverage could reduce tracking error on upward movement, but would increase the error when the index goes down: not only would the fund still have to pay back the loan (for debt-based leverage), but it would have to sell other assets at a low price to do so. Ouch.

There are other ways how a fund can reduce the impact of management fees. A very common way for funds using physical replication is securities lending: the ETF lends out some of its stock to short sellers for a fixed duration, after which they have to return the stock. The counterparty posts a collateral (such as cash) at the current value of the stock, and also pays a small premium. There still is some risk: if the counterparty defaults and the stock goes up by a lot, the fund is only left with the collateral+premium. However, this is a more manageable risk than depending directly on market movements.

In most cases, the income from securities lending goes to the management company, which (in theory) allows them to operate at a lower expense ratio. For Vanguard funds, the income generally flows back into the fund and can directly offset the TER, and can thus help achieve a real-world tracking difference of zero (or possibly even negative).

So the answer is: leverage is not generally used in index funds because better techniques such as securities lending exist. I'd also argue that funds in the 0.1x% TER regime are already so cheap (compared to market fluctuations and retail transaction costs) that no further optimizations are necessary. Of course, there are funds that explicitly use leverage as part of their investment strategy. But those typically have higher expense ratios (because they are more niche, and because managing them requires more effort, similar to active management). Those option contracts or loans don't come for free.

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When the index goes down, leverage will exacerbate the losses instead of offsetting them.

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Leverage has costs other than movement of the underlying: A leveraged ETF also loses value in response to volatility.

Also, your downside risk would be greater than it would otherwise be due to the leverage.

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That doesn't make sense. If the ETF is leveraged, then it shouldn't be tracking the index, it should be tracking a leveraged version of index. You're trying to engage in accounting shenanigans to hide the fee. Depending on how this were implemented, it could lead to prison time. If there are administrative costs, then they have to be collected somehow. You can't make money appear out of nowhere. In the case of leverage, the extra money is coming from extra risk. If you make money because you were willing to take on more risk, that extra money isn't free money. The risk needs to be priced in.

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