Many small investors buy leveraged ETFs hoping to juice up their returns. These ETFs promise 2x or 3x daily returns based off a benchmark. And wait, there even exists a leveraged ETF promising you 5x returns on Nasdaq 100. Isn’t it amazing?
But, as with everything, there is a price to pay. Leveraged ETFs come with one major warning and lots of fine print. If ignored, you may be positioning yourself for disappointment.
How Leveraged ETFs Work?
To get their 2x or 3x daily returns, leveraged ETFs use leverage as the name implies. They buy derivatives, such as swaps, futures or options. Derivatives allow you to put little capital and amplify returns several times.
For instance, here is TQQQ ETF’s portfolio.
It consists of a bunch swaps, common stocks and cash. By holding these index swaps, TQQQ leverages its Nasdaq 100 returns to 3x.
Leveraged ETFs Daily Rebalancing
Maintaining a constant leverage ratio is not an easy matter. Because the underlying index fluctuates, the leverage can get out of whack. For this reason, leveraged ETFs do daily rebalancing.
Let me give you an example. Suppose a leveraged 3x ETF has $100M in assets. These assets include derivative swaps that generate $300M exposure to a certain index.
Suppose the index rises by 1%. Such a move generates a gain of $3M for our ETF ($300M x 1%). The fund’s assets increase to $103M by the end of the trading day. The total exposure of the fund must always equal to 300% of its assets. For this reason, the fund manager will add $6M of exposure the next trading day. The reverse is true for declines.
Leverage and Compounding Dangers of Leveraged ETFs
This has profound implications. It is true that the daily performance will be almost always be close to 3x. But, the long-term performance will never be. In directional markets, the leverage will either balloon the fund’s assets or reduce them to nothing.
Directional Markets
Let’s come back again to our leveraged ETF with $100M in assets. Suppose the underlying index declines by 33%, but then recovers back up with a 49.25% increase the next day. What about our leveraged ETF? It plunges to (drum roll) $1M with a 99% decline. Later, the fund increases by 147.75% to $2.5M.
Of course this is an extreme case scenario, but it illustrates the point. In bear markets, leveraged ETFs can be wiped out. There is no question if, but rather when. The reason is simple. Any given decline requires a higher growth rate for a full recovery. As we saw, a 33% decline requires 49.25% growth for recovery for an index. But, with leverage, our ETF may never recover. The fund will be almost for sure liquidated leaving investors with nothing.
Of course, the opposite is true. In directional bull markets, leveraged ETFs will shine. For instance, consider 5 days of a 3% hypothetical growth in the underlying index.
This will produce 9% daily gains for the 3x leveraged ETF. Moreover, the compounding effect will produce an even higher cumulative gain of 53.9%.
Leveraged ETFs in Range Bound Markets
But, very often the stock market is range bound, going sideways with local ups and downs. And, this is the real killer for leveraged ETFs since their leverage will play against them. For instance, take the period from from 2022 to 2023.
S&P500 was range bound and only recently recovered to its peak with 0% gain. But, the 3x leveraged ETF UPRO showed a cumulative loss of 28% for the same period. The whipsawing is the real danger for leveraged ETFs.
Psychological Danger of Leveraged ETFs
Of course, when we zoom out, we see a massive outperformance. So, if someone sees this chart, they will be tempted to go all in.
But then, another issue pops up. Will you be psychologically prepared to stomach these massive drawdowns? Will you be able to wait it all out? Also, if you casually zoom in or out on the chart, you will notice huge underperformance depending on the timing.
Other Problems with Leveraged ETFs
Of course, there are a few other honorable mentions with these ETFs. First, they tend to have higher expense ratios compared to standard ETFs. While the ETF industry is moving towards a 0% expense ratio, TQQQ has a 0.88% ratio as of January 2023.
Second, leveraged ETFs’ derivative holdings are subject to time decay. This is also known as derivative’s theta. As time goes by, derivatives go down in value as they approach their expiration date.
Finally, in certain situations, leveraged ETFs may be getting poor prices for derivatives. Let’s say a certain leveraged ETF tracks an esoteric corporate bond index. If there is not enough derivatives volume, the ETF may pay higher prices. This will generate more cost for investors.
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Investors Takeaways
Leverage and compounding effects can devastate leveraged ETFs. Leveraged ETFs are most suitable for pros making short-term bets on market direction. As for everyone else, it is a bad idea.