Leveraged ETFs are risky but the returns are exceptional

Leveraged ETFs are getting more and more popular. However, understanding the underlying system in those Leveraged ETFs can bring exceptional returns to even average investors.

Leveraged Exchange-Traded Funds (ETFs) are a type of ETF designed to amplify the daily returns of a specified index or sector, offering a magnified exposure to the asset’s daily performance. By using derivatives, such as swaps, options, and futures contracts, leveraged ETFs can aim for 2x or 3x the daily performance of the target index. However, this magnification comes with unique characteristics and risks that make leveraged ETFs more suited for short-term trading rather than long-term investment.Here’s an in-depth breakdown of how leveraged ETFs work and why they differ from traditional ETFs:

1. Objective and Mechanism of Leveraged ETFs

Leveraged ETFs aim to achieve multiples of the daily performance of an underlying index, such as the S&P 500. For example:

• A 2x S&P 500 Leveraged ETF aims to deliver twice the daily performance of the S&P 500. If the S&P 500 gains 1% in a day, the ETF aims for a 2% gain. Conversely, if the index drops by 1%, the ETF would aim for a 2% loss.
• Inverse Leveraged ETFs go a step further by targeting negative multiples of the daily performance. For instance, a -2x leveraged ETF aims to produce the opposite return of twice the index’s daily movement. If the index drops 1%, a -2x leveraged ETF would ideally rise by 2%.

To achieve this daily leverage, leveraged ETFs use a combination of financial derivatives, which are instruments that derive their value from the underlying asset, allowing the fund to multiply the returns. While this leverage can lead to significant short-term gains if the index moves in the desired direction, it also increases the potential for amplified losses if the market moves against the fund.

2. Daily Reset and Compounding Effect

One of the most critical characteristics of leveraged ETFs is their daily reset feature. Leveraged ETFs rebalance their positions daily to maintain the target multiple, such as 2x or 3x. This daily reset can result in what’s known as the compounding effect over multiple days, leading to returns that may deviate from the target multiple over time. Here’s why:

• Daily Rebalancing: At the end of each trading day, a leveraged ETF adjusts its exposure to maintain the specified leverage for the following day. This adjustment is based on that day’s closing price, so each new day’s returns are calculated from a new base value.
• Effect of Compounding: Over multiple days, especially in a volatile market, the cumulative effect of daily returns can compound in a way that may not match the intended multiple. For instance, if an index fluctuates over several days but ends roughly at its starting value, a leveraged ETF tracking it may experience either a net gain or loss depending on the order and magnitude of daily fluctuations.

Example of Compounding

Consider a 2x leveraged ETF on an index that gains 5% on Day 1 and loses 4.76% on Day 2:

• On Day 1, a 5% gain means the 2x leveraged ETF increases by 10%.
• On Day 2, the index loses 4.76%, bringing it back close to its initial value, but the ETF will experience a 9.52% loss (2x the index loss), not fully offsetting Day 1’s gain due to compounding. Thus, even though the index returns to its original value, the leveraged ETF incurs a small net loss.

This compounding effect can significantly impact returns over time, often leading to outcomes that diverge from simply applying the leverage factor to the index’s overall performance over longer periods.

3. Volatility and Suitability for Short-Term Holding

Leveraged ETFs experience greater volatility than their underlying index, which makes them more attractive to short-term traders looking to benefit from daily price movements. However, this same volatility poses risks for long-term holders:

• Volatile Daily Swings: Due to the amplified nature of leveraged ETFs, they can experience larger daily price swings than their underlying assets. For example, while the S&P 500 might move by 1%, a 3x leveraged ETF would see a 3% change.
• Time Horizon Suitability: Leveraged ETFs are generally better suited for short-term or intraday trading strategies because their returns align most closely with the target multiple on a day-to-day basis. Long-term holding can expose investors to performance that deviates from the target multiple, especially in fluctuating or sideways markets.

4. Costs and Risks of Leveraged ETFs

Investors should consider the additional costs and risks associated with leveraged ETFs:

• Expense Ratios and Transaction Costs: Leveraged ETFs often have higher expense ratios compared to traditional ETFs due to the complex management required to maintain the leverage. Additionally, frequent rebalancing incurs trading costs that can erode returns over time.
• Potential for Significant Losses: Leveraged ETFs can experience substantial losses during downturns due to their amplified exposure. In a market decline, losses are magnified, potentially resulting in a rapid erosion of capital.
• Market Timing Risk: Because leveraged ETFs are particularly sensitive to timing, entering or exiting during volatile periods can impact returns significantly. This factor makes them challenging to use without a disciplined strategy for buying and selling, especially for investors without short-term market timing experience.

5. Strategic Use and Alternatives

For investors who are interested in leveraged exposure but wish to hold their investments longer, here are some strategic considerations:

• Trend Following or Stop-Loss Strategies: Some investors use technical indicators, such as the 200-day moving average, to decide when to enter or exit leveraged positions, reducing the risk of holding through significant downturns.
• Combination with Traditional ETFs: Blending leveraged ETFs with traditional ETFs in a diversified portfolio can help moderate risk while providing opportunities for higher returns. This approach can offset the amplified risks of holding only leveraged assets.

Conclusion

Leveraged ETFs offer a powerful tool for investors seeking to capitalize on short-term market movements, but they require careful consideration due to their unique structure and risks. The daily reset feature, volatility, and high compounding effect make them best suited for traders with a high risk tolerance and short investment horizons. Long-term investors may benefit from exploring alternatives or using leveraged ETFs as a small part of a diversified portfolio, employing risk-management techniques to navigate their amplified risks and costs.

By understanding these characteristics, investors can make more informed decisions on when and how to use leveraged ETFs effectively, aligning them with their risk tolerance and financial goals. You can find a good comparison between Leveraged ETFs and Traditional ETFs.