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Fatal Attraction

Sanjib Saha

HOW WOULD YOU feel about a stock market strategy that routinely invests more after prices go up and sells when prices drop? As someone who invests for the long haul, I’m skeptical—which is why the increasing popularity of leveraged exchange-traded funds (ETFs) puzzles me.

A leveraged ETF aims to amplify the daily return of its stated benchmark. The fund’s benchmark might be a widely followed stock or bond index, a particular market sector, a single industry or one country. These ETFs are easily identified by their names, which often include terms like 2x, 3x, bull and ultra. For instance, ProShares Ultra S&P 500 (symbol: SSO) seeks to return twice the daily performance of the S&P 500-stock index, while Direxion Daily MSCI India Bull 3X Shares (INDL) tries to triple the daily return of Indian stocks.

Leverage is a double-edged sword that exaggerates both gains and losses—often costing investors dearly. Yet a wrongheaded narrative keeps attracting inexperienced investor to leveraged ETFs. Consider ProShares Ultra S&P 500, mentioned above.

It lost almost 20% in the five years following its June 2006 launch, including dropping more than 80% from peak to trough during the 2007-09 bear market. In the same five-year period, a low-cost S&P 500 ETF would have gained a cumulative 15% with half the volatility. Wasn’t the ProShares ETF supposed to double the benchmark’s gain, by rising 30% over the five years, instead of losing 20%? This is the dangerous misconception about leveraged ETFs—and the reason they shouldn’t be used as long-term investments.

Instead, leveraged ETFs are tools for sophisticated day traders and swing traders. They’re meant to be held for a day or so and kept under close watch. When market timers are firmly convinced about the market’s immediate direction, they try to use leveraged ETFs to make a quick buck.

Fund companies emphasize that the stated performance goal of a leveraged ETF is strictly a daily target. A 2x ETF is structured to generate—before costs—twice the gain or loss that the benchmark experiences during the course of a single day. Its return over longer holding periods is anyone’s guess.

To illustrate the effect of mandating a daily target, suppose we mimic a 2x S&P 500 ETF starting with $100. To double our market exposure, we borrow another $100, allowing us to buy $200 worth of S&P 500 stocks. By keeping the debt at the same level as our “net balance”—meaning our account value after deducting the debt—we can earn twice the market’s return for that day.

As the market moves in either direction during the day, the portfolio’s gross value changes proportionally, but the debt remains constant, thus amplifying changes in our portfolio’s net balance. For instance, if the market goes up by 25% on the first day, the stocks rise from $200 to $250. Our net balance, after subtracting the $100 loan, is—voilà!—$150, a 50% gain on our initial $100 investment.

At the close of that first day, the $100 debt is below our $150 net balance. As a result, we’re no longer positioned to generate twice the market’s return the next day, so we need to take on more debt. We do that by borrowing another $50 to buy more S&P 500 stocks, thus ensuring our debt is equal to our net balance of $150. In other words, if prices rise on day No. 1, the daily performance goal compels us to buy more stocks before day No. 2.

Leveraged ETFs do the same thing. In practice, they don’t buy stocks with borrowed money. Instead, they use indirect leverage through derivatives. But conceptually, their rebalancing is the equivalent of buying more after prices rise.

What if the market had gone sour on the first day and dropped 20%, instead of rising 25%? In our portfolio that mimics a 2x ETF, the value of our stocks would drop from $200 to $160. After subtracting the $100 outstanding debt, our net balance falls to $60, a 40% drop.

Our portfolio is now overleveraged, so we need to make adjustments to set us up to earn twice the market on day No. 2. This time, we have to reduce borrowing to bring it to the same level as our net portfolio balance. That means selling stocks worth $40 and using the proceeds to bring down the debt from $100 to $60, so it’s the same as our net balance. In other words, we’d be obliged to sell stocks because their prices have fallen. Again, similar adjustments happen with a leveraged ETF.

This daily rebalancing causes the leveraged ETF to buy stocks after prices rise and sell after prices drop, day in and day out. The continuous adjustment of the leverage causes the long-term performance to deviate significantly from the daily target. Indeed, thanks to the costs involved and the difficulty in recouping losses suffered on down days, a leveraged ETF can lose money over longer periods even when the underlying benchmark posts gains in the same timeframe.

What would happen to a triple leveraged ETF if its benchmark dropped by a third in a single day? You guessed it: The ETF would be wiped out. But even if a leveraged ETF survives a big market drop, the underlying benchmark has to soar for the ETF to recoup its loss. A 20% drop of an unleveraged asset requires a subsequent 25% gain to break even. In the case of a leveraged ETF, a 20% benchmark drop leads to a 40% drop in the fund’s value. Result: The fund needs to go up by almost 67% to break even, which can only happen if the benchmark rises by more than 33%.

Market volatility can be devastating for leveraged ETFs, even when the underlying benchmark recoups its losses. Suppose that Mr. Market goes up 10% on day No. 1 and down by 9% on day No. 2, and follows this whimsical pattern for a year. Despite the extreme volatility, the market would be up by 0.1% over any two-day stretch and, over the course of a year, its rise would exceed 13%.

How does a 2x ETF fare in the same year? It experiences a 20% gain on day No. 1 and an 18% drop on day No. 2. Compounding the daily returns, the ETF loses 1.6% over two days. If this seesaw continues for a year, the ETF would lose almost 87% of its original value.

Even on a profitable day, the pretax profit of a leveraged ETF is likely to be less than its stated goal. Why? The leverage isn’t free. If the ETF uses a total return swap—a contract that gives the return exposure of an asset without having to own it outright—it has to pay interest for the swap contract. The already high expense ratios of these ETFs, typically close to 1% and sometimes more, don’t include either the cost of leverage or the fund’s trading costs.

The bottom line: If I could get my hands on a crystal ball that accurately predicts short-term market movements, I’d use leveraged ETFs in a heartbeat. Until then, count me out.

A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Identity CrisisTriple Blunder and Freedom Formula. Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.

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Rick Connor
Rick Connor
1 year ago

Sanjib, thanks for a very interesting and enlightening article. I’ll bet the vast majority of people who invest in these are unaware of the math.

Sanjib Saha
Sanjib Saha
1 year ago
Reply to  Rick Connor

Thanks, Rick.

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