Thinking about a Leveraged ETF?

Tyler Kert
Tamarack Wealth Management

In the past few months, I’ve had several clients ask me about leveraged ETFs. It’s not surprising because recently many of them have been posting returns that seem too good to pass up. There are many to choose from. Some of the more popular ones seek to deliver three times the daily return of the Nasdaq or the S&P 500. When technology stocks are soaring and markets are moving steadily upward, these funds can produce incredible returns. Looking at those performance numbers, it's easy to wonder: Why doesn't everyone invest in these?

Before we answer that question, let's start with the basics. An Exchange Traded Fund, or ETF, is simply a basket of investments that trades on a stock exchange like an individual stock. ETFs have exploded in popularity because they allow investors to gain broad diversification, low costs, and easy access to different parts of the market. Most ETFs track an index. For example, an S&P 500 ETF owns shares of the companies within the S&P 500 and rises or falls with that particular index. Leveraged ETFs are different.

Rather than simply owning stocks, leveraged ETFs use financial contracts, like futures and swap agreements, to amplify the daily movement of an index. If the S&P 500 index goes up 2% in a day, a 3x leveraged ETF tracking that index will go up 6%. Now, the key word is daily. Many investors hear about leveraged ETFs and think, “If the stock market averages 8-10% a year over the long term, I can invest in this leveraged ETF and get 24-30% over the long term.” Unfortunately, that's not how it works.

Leveraged ETFs are designed to deliver three times the return of the index each day, not over months or years. To achieve that, the fund must rebalance every single day. That daily reset causes something known as volatility decay. It sounds complicated, but an example helps bring some clarity. You just have to remember that percentages are not symmetrical. Suppose you have an investment that is worth $1,000 and it loses 10%. It now sits at $900. If it gains 10% the next day, you’re back to where you started, right? Wrong! It doesn't return to $1,000. It only rises to $990. If you have to go back and double check my math again, be my guest. The loss and gain are not equal because they are being calculated from different starting points.

Now add leverage to the equation. Imagine an index starts at 1,000. On day one it falls 10%, dropping to 900. On day two it rises 11.1%, bringing it right back to 1,000. An investor in the index is essentially back to where they started. A 3x leveraged ETF tells a different story. Day one, the investor loses 30%, reducing their value from 1,000 to 700. Day two, they gain 33.3%, bringing their account to roughly 930. The index recovered completely, but the leveraged investor is still down about 7%.

The leveraged ETF isn’t broken. It did exactly what it promised to do. The issue is that many investors assume they're buying three times the long-term return of the market when they're actually buying three times the daily movement. In a strong, steadily rising bull market, leveraged ETFs can be incredible performers. The last decade has been especially favorable for them, with long periods of growth and relatively low volatility. But markets don't always move in straight lines. There have been several periods in the past where leveraged strategies, if they were in existence, would have struggled badly. The decade from 2000 through 2009 is one of those times. The S&P 500 produced virtually no net gain over the entire period. A buy-and-hold investor likely would have endured a frustrating decade, but a heavily leveraged investor could potentially have experienced far more severe losses.

In summary, leveraged ETFs are not a broken mechanism. They are just commonly misunderstood as producing 3x the long-term results of an index rather than the daily performance of an index. For long-term retirement investing, leveraged ETFs may not be appropriate. Sometimes the better question isn't how much you can make when markets go up. It's how much you might lose when markets don't cooperate.

This material is for informational purposes only and does not constitute financial, investment, or tax advice. Please consult your tax advisor or financial planner to discuss your specific circumstances before making any decisions. Securities offered through Cetera Wealth Services LLC, Member FINRA/SIPC. Advisory services offered through Cetera Investment Advisers LLC, a registered investment adviser. Cetera is under separate ownership from any other named entity.

Tyler Kert, a financial advisor and CPA, provides financial planning and tax consulting services at Tamarack Wealth Management in Cashmere, WA. 209 Woodring Street, Cashmere, WA 98815. (509) 300-1040.

Exchange-traded funds are sold only by prospectus. Please consider the investment objectives, risks, charges and expenses carefully before investing. The prospectus contains this and other information about the investment company, can be obtained from your financial professional at 509-300-1040 or 209 Woodring Street, Cashmere, WA 98815. Be sure to read the prospectus carefully before deciding whether to invest. The views stated in this letter are not necessarily the opinion of Cetera Wealth Services, LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.  Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing. S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. This does not represent any specific product [and/or service].