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 10.3% for the five years ending February 26, 2020. 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 21.6% over that same five year period.
Performance deviations, which is also known as tracking error, get even larger for extremely volatile market segments. The MSCI Russia Index has returned 14.1% annualized for the five years ending February 26, 2020. Over that same time period, the Direxion Daily Russia Bull 3X ETF (RUSL) returned 2.9% annualized, falling well short of returning three times the longer-term return of the benchmark. Meanwhile, the Direxion Daily Russia Bear 3X ETF (RUSS) returned -49.5% annualized, which is greater than three times the negative return of the benchmark. The longer-term impact of using leverage to magnify short-term market moves led to the 3x inverse Russia ETF to have much greater losses than expected while the 3x Russia ETF that one would expect to return more than the overall Russian stock market fell woefully short.
That doesn’t mean that leveraged ETFs are flawed. They come close to achieving their 2x and 3x goals on a daily basis but their longer-term returns will fall short of the 2x or 3x the benchmark return. The mathematics of compounding will prevent that.
Learn More About the Possibilities and Risks of ETFs
In the chapter of my book on Investment Vehicles, I go in-depth on ETFs and how to avoid possible risks. You can learn more about and purchase my book here.
While the significant growth in ETFs has given investors access to many different asset types at a very low cost, that convenience has not come without risk. Academic studies show that the growth in ETFs has increased the volatility of both the indices that ETFs track and the underlying securities ETFs own…
While ETFs appear straightforward and easy to use, there is a great deal of complexity lurking beneath the surface. One of our responsibilities as portfolio managers is to make sure we get the best price when initiating trades for our accounts.