Leveraged ETFs: What They Are and Why They Can Be Dangerous

Exchange-traded funds (ETFs) have become popular in recent years, as they provide investors with exposure to a broad range of assets. Among these ETFs are leveraged ETFs, which generally aim to deliver two or three times the daily return of a given underlying index. However, these types of ETFs can be risky for investors due to a phenomenon known as ETF decay or volatility drag.

How Leveraged ETFs Work

Leveraged ETFs work by using borrowed funds to invest in the underlying assets, often using derivatives such as futures or options. When the value of the underlying assets goes up, the fund makes money, and when it goes down, the fund loses money. The goal of a leveraged ETF is to amplify the returns of the underlying assets. For example, if the underlying asset increases by 1%, a two-times leveraged ETF would aim to return 2%.

However, leveraged ETFs are designed to deliver these amplified returns on a daily basis rather than over an extended period. This means that over time, the daily returns can add up, leading to a discrepancy between the ETF's returns and the returns of the underlying assets. This discrepancy is what is known as ETF decay or volatility drag.

ETF decay occurs because the daily returns of the ETF are compounded, which means that even small deviations from the expected return can add up over time.

How Leveraged ETFs Can Lose You Money — An Example

Here’s an example of how a leveraged ETF could be dangerous. If the underlying asset increases by 1% on day 1, the net asset value (NAV) of the two-times leveraged ETF should increase by 2%, from $100 to $102.

Then, if the underlying asset decreases by 1% on day 2, the NAV of the two-times leveraged ETF should decrease by 2%, from $102 to $99.96.

This means that the two-times leveraged ETF lost 0.04% of its value over the two-day period, even though the underlying asset had a net change of 0.01% (101 - 1% = 99.99). This illustrates the effect of compounding and how it can cause leveraged ETFs to underperform their underlying assets over longer holding periods.

The dangers of ETF decay are especially pronounced in volatile markets, where daily returns can fluctuate significantly. Suppose the underlying asset experiences a series of ups and downs over an extended period. In that case, the leveraged ETF will have to keep buying and selling assets to maintain its target leverage, resulting in transaction costs that further erode returns.

Another danger of leveraged ETFs is that they are not suitable for long-term investors. The daily compounding of returns means that the ETF's returns will diverge from the returns of the underlying assets over time. Therefore, investors who hold leveraged ETFs for an extended period are likely to experience significant losses.

Leveraged ETFs Can Be Useful, Though

Still, leveraged ETFs can also be beneficial for investors who are looking to capitalize on short-term market movements. These ETFs can provide a way to amplify returns in a specific asset class, such as stocks or bonds. For example, suppose an investor believes that the stock market will rise over the next few days. In that case, they could invest in a two-times leveraged ETF that tracks the S&P 500 index. If the index goes up by 1%, the ETF would aim to return 2%, providing the investor with a higher return than they would have received by investing directly in the index.

Leveraged ETFs can also be used as part of a diversified portfolio. Suppose an investor has a diversified portfolio of stocks, bonds, and other assets. In that case, they could invest a small percentage of their portfolio in leveraged ETFs to boost returns. However, this strategy should only be used by experienced investors who understand the risks involved.

Nonetheless, ETF decay or volatility drag is a real danger for investors in leveraged ETFs. These ETFs are designed to deliver amplified returns on a daily basis, and over time, the daily returns can accumulate, resulting in a significant discrepancy between the ETF's returns and the returns of the underlying assets. Essentially, leveraged ETFs can also be beneficial for short-term investors or day traders looking to make a leveraged bet.