Leveraged ETFs are a bad idea. Period. (2024)

They’re a popular investment option, but how exactly does a leveraged ETF work?

A leveraged ETF holds a basket of positions purchased with a certain amount of margin, or a line of credit that the fund sponsor maintains with the broker dealer they trade through. Here’s a hypothetical example of how leveraged ETFs work.

A three times leveraged ETF, or Leveraged ETF 3x, holds positions on three times leverage. Exposure to the gains and losses of the underlying index are magnified by three times.

If you held underlying index XYZ directly and then levered it up three times directly with your broker dealer, the losses could potentially cause your position to fall below zero. In other words, you could potentially be liable for more than you invested because you bought the position on leverage.

But can a leveraged ETF go negative?

No.

If you own a leveraged ETF you can’t lose more than your initial investment amount. You would never be liable for more than you invested; in a sense, the amount you could lose is capped. However, that doesn’t take away the very significant risks that do prevail, such as high volatility and tracking error, or failure to mirror the returns of the index you are purported to track.

In our view, leveraged ETFs can be great when there is a bull market.

However, when positions are held with leverage, losses compound quickly. Remember that by the power of compounding, any loss requires more than the original extent of decline to return to be recouped.

For example, if you were to lose 20% on a $100 investment, you will have $80. The investment would have to come back by more than 20% to get you back to the $100 you originally had – in fact, you’d have to earn 25%. That’s why catastrophic losses aren’t that easy to come back from.

This concept is particularly problematic for a leveraged ETF’s daily rebalancing, which is commonly overlooked.

Here’s how this works. A leveraged ETF rebalances daily to maintain the proper ratio of margin to assets. The effect this has on the overall instrument’s performance is very sobering.

What is a daily rebalancing (also called a “reset”)? It’s important to understand this if you are considering investing in these vehicles.

Here’s an example.

The following table illustrates the potentially harmful impact of compounding with leverage in a down market. Let’s say you invested in a 2x leveraged ETF with a starting price of $100 per share, and the index performed as such over the next four days.

The column on the left is the index; the column on the right is the ETF’s index exposure per share owned.

Due to the fact that you compounded losses, you lost more than the 5% you would have lost if you held an unleveraged ETF that tracked the index 1 to 1. In fact, you lost more than double the 5% the index lost - due in part mostly to the effect of daily resets.

Here’s what happens behind the scenes in a situation like this, and why it drives up cost. Suppose this 2x leveraged ETF has $100MM in assets on one day when you bought in.

Now here’s the thing. Because this is a 2x leveraged ETF, the fund needs to have $180MM in index exposure for tomorrow to maintain its leverage ratio of 2 to 1. Otherwise, it doesn’t track the index it said it would track. The fund has to reduce its index exposure. How does it get from $200MM to $180MM? It has to trade derivatives such as index futures and equity swaps, the cost of which is quite significant (we’ll get to that in #3!).

So the fund sponsor does that, and the market opens the next day.

To maintain its 2:1 leverage ratio, the fund needs index exposure of $217.90MM, or $37.9MM more than what it started with the previous day. Again, the fund has to trade derivatives to gain this level of index exposure.

Which leads us to the third drawback of leveraged ETFS – they’re potentially very expensive.

One of the benefits of investing in ETFs is their low cost. However, leveraged ETFs tend to run on the expensive side of the ETF spectrum.

You aren’t paying for the margin as you would if you were to leverage up your portfolio yourself, but the fund sponsor certainly isn’t letting you get anything for free. You won’t have to pay margin interest or deposit more collateral – but there’s a price for the convenience of letting the ETF take care of that. Leveraged ETFs hold derivatives, and resetting them on a daily basis is costly. They must pay transaction costs and interests costs because they trade derivatives.

Compared to non-leveraged ETFs, these vehicles tend to be very expensive. High cost of investment erodes investor wealth over time which is why we advocate for investors to pursue low-cost investments and follow a long-term strategy.

For all of the reasons stated in this blog, we feel that leveraged ETFs aren’t what they are cracked up to be. The S&P 500 may be down 10% over a period of time but an investor in a short S&P 500 index won't be up 10% over that same period of time.

People often view Leveraged ETFs as an appealing way to increase return potential. We see this as an attempt to take a shortcut to wealth creation. They may be appropriate for a day trader, but they aren’t necessary for long term investors. We think they are a bad idea and the only viable use that we see making sense is to use them to hedge on a short-term basis.

The best way to grow your wealth over time is to craft an appropriate asset allocation and follow it for the long term. Proper assessment of your risk tolerance in accordance with your long-term goals must be attained.

We are a financial advisor in the Philadelphia area, but we work with clients across the country. We provide fee-only, objective advice to our clients. If you would like to discuss a possible relationship, contact us.