Everyone wants to see their portfolio increase in value. It’s the reason for investing. Investors in today’s time are consistently barraged by news, solicitations for financial products and competitive micro influences that make you question if you are doing enough in your portfolio. So, there is no surprise that investing eventually leads to the question of how to get even better returns in less time. Starting in 2006, some Wall Street firms have tried to capitalize on this emotion with leveraged ETFs.
What are Leveraged ETFs
Leveraged ETFs are simply ETFs (Definition of ETF) that have additional amplification of returns by utilizing derivatives and debt. The firms selling these generally use borrowed money for the acquisition of options contracts, to track the daily return at a specific multiplier. You will typically see a leveraged ETF in the form of “2X” or “3X” of the index it tracks (3X S&P 500 ETF for example), meaning that the ETF tracks the daily price movement with a 2X or 3X multiplier.
At first sight, this may seem like a wonderful idea. After all, if you are bullish on a particular index or industry, why not capitalize on the gains? Unfortunately there are some considerable drawbacks, and we have outlined four primary reasons to avoid leveraged ETFs below.
Reason #1: Compounding Losses Outweigh Gains
This is the most significant reason to watch out for leveraged ETFs. Just as a leveraged ETF can produce magnified gains, the exact same thing can happen with losses. What is important to consider here is the compound effects of losses on the overall asset.
Let’s take the scenario below, in which an index we are tracking falls four trading days in a row, by 1.5% each day. Then, on the last day, it recovers by 6.23%, bringing the original investment of $100 back to even. Notice the returns of the 3X leveraged ETF. Even with the momentous gain of 18.69% (6.23% multiplied by 3), it does not return to the initial investment value.
This is because losses are magnified even further with compounding. Over time, a leveraged ETF will perform poorly relative to a normal index ETF.
Reason #2: Fees
Leveraged ETFs, unlike passively managed index ETFs, are actively managed. They typically have fees that can go unnoticed if you do not take the time to do your research. These fees are called expense ratios. While essentially all Mutual Funds and ETFs have a non-zero expense ratio, they typically are considerably higher than the standard index ETFs. This can add up over time and really reduce overall performance. Make sure you take the time to evaluate the fees before making any decision to invest.
Reason #3: Liquidity
If you must dabble with leveraged ETFs, be sure to check the average volumes to ensure there will be enough liquidity. This ensures that when you decide to sell you are able to execute the trade close to the market price. Low volume can seriously harm investors, especially on a down day, if you are attempting to exit a position and can’t get the order filled. Some leveraged ETFs trade with significantly lower volumes than their normal index counterparts, so you will want to check this before entering. In fact, as a rule you should be sure to check this for any position you enter.
Reason #4: Built for Traders, not Long-Term Investors
Leveraged ETFs consistently draw criticism from Wall Street. This is because of the widespread opinion that a leveraged ETF is a tool for traders, and not long-term investors. Because of the heightened volatility and effects of compounding losses, this can drag down your portfolio over the long-term.
You can never time the market, and we believe that you can set yourself up for serious risk by attempting to enter a position in a leveraged ETF. Even with the intent of only holding for the short-term.
Summary
There can certainly be some positive upside to a leveraged ETF in the form of amplified gains for short-term trading. However, we believe they do not suffice as a worthwhile long-term investment.