Question: After hearing from a guy who stated he made a killing in a 3x leveraged ETF this year, I’ve been considering investing in one. They appear to be rather attractive, however I recently read an article claiming that leveraged ETFs do not perform well in general. So, what’s the real story here?
Answer: Congratulations on your friend’s profitable trade. I’m delighted everything worked out so well for him. While he’s still buzzing from his big success, he should read my January column, ” “Confessions of a Bull Market Genius” is a book about a bull market genius. If you’re interested, please let me know and I’ll email you a copy.
For those unfamiliar with leveraged ETFs, they strive to achieve a return equivalent to a multiple of an index’s daily price move. The Direxion Daily S&P 500 Bull 3x ETF (symbol: SPXL), for example, provides investors with three times the daily return on the S&P 500 index. On other words, if you own SPXL and the S&P 500 index rises 5% in a day, you should expect a 15% increase in your stake. SPXL is a bullish fund, which means it rises and falls in tandem with the market. There are also bearish funds that move in the opposite direction of the market.
To maintain continuous leverage, a leveraged ETF is rebalanced every day. If you keep a leveraged ETF for more than one day, the daily rebalancing can result in a phenomenon known as the “dead cat bounce.” “The Trap of Constant Liquidity.” Consider the following two-day example of investing $10,000 in SPXL to see how this works. Hold on, there’ll be some math involved.
Do leveraged ETFs rebalance every day?
To maintain a stable leverage ratio, most leveraged ETFs reset to their underlying benchmark index on a daily basis. This resetting procedure results in a condition known as the continual leverage trap, which is not how standard margin accounts work.
Given enough time, the price of an asset will eventually fall to the point where it may cause significant damage or perhaps wipe out highly leveraged investors. In October of 1987, the Dow Jones, one of the world’s most reliable stock indices, plummeted roughly 22% in one day.
Why do leveraged ETFs perform poorly?
The issue is that the market does not move in a straight line up or down. Instead, multiple daily positive and negative moves lead to a long-term positive return (ideally!). In the long run, however, exchange-traded funds that follow and compound daily movements invariably trail their index (and finally provide negative returns).
ETFs that are triple leveraged depreciate significantly faster than ETFs that are double leveraged. Direxion’s TNA fund, for example, monitors 3x the daily change in the Russell 2000 index. The fund has provided a disappointing 32 percent return since its inception in late 2008, compared to a 66 percent return for the Russell 2000 index.
Despite its 3x leverage, the leveraged fund outperformed the benchmark by 32 percent, compared to 66 percent for the index.
As a result, you’d have been better off simply investing in the underlying index!
What is a leveraged ETF rebalancing?
It’s difficult to keep a constant leverage ratio, which is usually two or three times the amount. The value of the leveraged fund’s assets changes when the price of the underlying index fluctuates, necessitating a change in the overall amount of index exposure.
A fund with $100 million in assets and $200 million in index exposure, for example, has $100 million in assets and $200 million in index exposure. The index gains 1% on the first day of trade, resulting in a profit of $2 million for the company. (In this example, assume no expenses.) The fund’s assets are currently $102 million, but it has to increase (in this example, double) its index exposure to $204 million.
Maintaining a stable leverage ratio allows the fund to reinvest trading profits right away. This continual adjustment, also known as rebalancing, is how the fund is able to provide twice the index exposure at any given time, even if the index has recently gained or lost 50%. The fund’s leverage ratio would change every day if it wasn’t rebalanced, and the fund’s returns (in comparison to the underlying index) would be unpredictable.
Rebalancing a leveraged fund with long exposure in a weakening market, on the other hand, might be difficult. Reducing the fund’s index exposure allows it to weather a downturn and avoid future losses, but it also locks in trading losses and reduces the fund’s asset base.
For example, suppose the index loses 1% every day for four days in a row before gaining +4.1% on the fifth day, allowing it to recoup all of its losses. What would the performance of a two-times leveraged ETF based on this index have been over the same time period?
Our index had returned to its starting point at the end of the week, but our leveraged ETF was still down marginally (0.2 percent ). This is not a rounding error, but rather the outcome of the leveraged fund’s proportionally lower asset base, which necessitates a higher return, 8.42 percent in reality, to return to its former level.
In this case, the effect is minor, but in highly volatile markets, it can grow large over time. The greater the percentage drops, the greater the differences.
Simulating daily rebalancing is straightforward mathematically. All that is required is a twofold increase in the daily index return. Estimating the influence of fees on the portfolio’s daily returns, which we’ll examine in the next section, is far more difficult.
How long can you keep leveraged ETFs in your portfolio?
We estimate holding period distributions for investors in leveraged and inverse ETFs in this article. We show that a significant fraction of investors can keep these short-term investments for longer than one or two days, even a quarter, using standard models.
Are leveraged ETFs a suitable long-term investment?
The response is a categorical NO. Leveraged exchange-traded funds (ETFs) are designed for short-term trading. Long-term holding of a leveraged ETF can be extremely risky due to a phenomena known as volatility decay.
Can a leveraged ETF go negative?
Even when the underlying index performs well, leveraged ETFs can perform poorly over longer time periods. The geometric nature of returns compounding and ill-timed rebalancing are to blame for the longer-term underperformance. The author shows that highly leveraged ETFs (3x and inverse ETFs) are likely to converge to zero over longer time horizons using the concept of a growth-optimized portfolio. 2x leveraged ETFs can similarly be predicted to decay to zero if they are based on high-volatility indexes; however, in moderate market conditions, these ETFs should avoid the fate of their more heavily leveraged counterparts. The author proposes that an adaptive leverage ETF might produce more appealing results over longer time horizons based on these concepts.
What makes leveraged ETFs volatile?
Daily rebalancing is used by leveraged ETFs, thus while they multiply an index’s daily returns, this does not imply that they provide the same multiple of long-term returns, such as yearly returns. Indeed, the bigger the leverage multiple, the more volatile the market gets.
Is a leveraged ETF a poor investment?
Compounding isn’t always a bad thing for a mutual fund’s performance. Let’s say a double-leveraged fund increases by 10% three days in a row. It would yield a 33.1 percent return. If the index increased 5% on each of those days, the leveraged three-day return would be more than double the index’s 15.8 percent return. A leveraged fund’s best friend is a strong uptrending market.
This year’s market is an excellent illustration of a robust uptrending market with low volatility.
That’s when leveraged funds come into play. The S&P 500 has gained 25% in the last week. The Direxion Daily S&P 500 Bull 3X (SPXL), which is supposed to move three times the S&P 500, is up 91%.
Bottom line: Leveraged and inverse ETFs work well for day traders, but they perform poorly when the market becomes volatile due to compounding and tracking error. They aren’t suitable for long-term investment.
Vanguard offers leveraged ETFs.
Vanguard discontinued accepting purchases of leveraged or inverse mutual funds, ETFs (exchange-traded funds), and ETNs on January 22, 2019. (exchange-traded notes). If you currently own these investments, you have the option of keeping them or selling them.
What are 3X leveraged exchange-traded funds (ETFs)?
Leveraged 3X ETFs monitor a wide range of asset classes, including stocks, bonds, and commodity futures, and use leverage to achieve three times the daily or monthly return of the underlying index. These ETFs are available in both long and short versions.
More information on Leveraged 3X ETFs can be found by clicking on the tabs below, which include historical performance, dividends, holdings, expense ratios, technical indicators, analyst reports, and more. Select an option by clicking on it.