What is a leveraged ETF?
Leveraged exchange-traded funds (ETFs) are a type of ETF that uses debt or other forms of leverage, such as futures or options, in an attempt to capture two to three times the daily performance of a target index.
Some leveraged ETFs produce returns in the same direction of the index while inverse leveraged ETFs strive for returns that are opposite the benchmark returns. When the index jumps in price, the inverse ETF’s price falls. The difference between leveraged ETFs and regular ETFs is leveraged ETFs seek to double or triple the target benchmark’s daily performance, be it in the same direction of the index or its opposite in the case of inverse ETFs.
Daily Performance Not Monthly
Leveraged ETFs usually include the words “pro” or “ultra” to distinguish them from less volatile ETFs that don’t use leverage. The volatility of leveraged ETFs makes them suitable only for short-term traders. The reason is severe price swings due to leverage keeps leveraged ETFs from returning two to three times the benchmark performance over longer time periods. The mathematics of compounding is why leveraged ETFs fall short over longer holding periods. ETF sponsors are quite clear in their written materials that the leveraged ETFs are seeking to replicate two to three times the daily performance of the target index. Not the monthly or annual performance.
Leveraged ETF Examples
For example, the S&P 500 Index has returned approximately 10.9% for the five years ending November 25, 2019. You would think a triple leveraged ETF seeking to generate 3x the performance of the S&P 500 Index would have returned over 30% annualized over that five-year period. Yet the ProShares UltraPro S&P 500 ETF (UPRO), a triple leveraged ETF that seeks to generate three times the daily performance of the S&P 500 Index, only returned 23.7% over that same five year period.
Performance gets even more weird for extremely volatile market segments. The MSCI Russia Index has returned 11.3% annualized for the five years ending November 25, 2019. Over that same time period, the Direxion Daily Russia Bull 3X ETF (RUSL) returned -10.6% annualized while the Direxion Daily Russia Bear 3X ETF (RUSS) returned -52.1% annualized. Both ETFs lost money due to the volatile daily swings in the Russia stock market.
That doesn’t mean that leveraged ETFs are flawed. They come close to achieving their 2x and 3x goals on a daily basis but that does not mean their longer-term returns will be 2x or 3x the benchmark return. The mathematics of compounding will prevent that.