Leveraged ETF Ins and Outs for Long-Term Investing | The Motley Fool (2024)

Investors use plenty of tricks in their attempts to beat the overall performance of the stock market. Leveraged exchange-traded funds (ETFs) fit into this category. A leveraged ETF generally tracks a stock market index, industry, or asset class, and uses debt to boost the fund's return. Buying shares in a leveraged ETF poses certain risks, which investors should be clearly aware of before making any investing decisions.

Leveraged ETF Ins and Outs for Long-Term Investing | The Motley Fool (1)

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What is a leveraged ETF?

What is a leveraged ETF?

A leveraged ETF (exchange traded fund), which holds both debt and shareholder equity, uses the debt to amplify the daily return to shareholders. Non-leveraged ETFs, by contrast, hold only shareholder leveraged equity and simply track an underlying index or asset class with the goal of matching that index or asset's performance. Fund managers of leveraged ETFs aim to generate daily returns that are multiples of the performance of the underlying index or asset class with the objective of earning returns that exceed the cost of assuming the debt.

Leveraged ETFs may also use derivatives -- such as options and futures contracts -- to amplify returns. Inverse leveraged ETFs use derivatives to generate the opposite of the daily return of an index or asset class. Investors who expect the value of an index or asset class to decline, much like short sellers, may buy shares in an inverse leveraged ETF. Some inverse leveraged ETFs aim to generate a multiple of the opposite of the daily return of an index or asset class.

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Exchange-Traded Fund (ETF)

An exchange-traded fund, or ETF, allows investors to buy many stocks or bonds at once.

How leveraged ETFs work

How leveraged ETFs work

The easiest way to explain how leveragedfunds work is to provide a few examples. Let's assume that you hold shares in a triple-leveraged ETF that tracks the S&P 500 (SNPINDEX:^GSPC) and that the index loses 20% of its value in a month. Your shares in the leveraged ETF would lose roughly 60% of their value. If the ETF was not leveraged, the value of the S&P 500 would need to rise by about 25% for you to recoup your losses. (If an asset loses and regains value, the regained value represents a larger proportion of the value of the asset at its reduced amount.) But with the triple-leveraged ETF, the S&P's value would need to rise by 50% and the value of your shares in the ETF by 150% to recoup those same losses.

The ProShares Ultra S&P 500 ETF (SSO 1.33%) is a leveraged ETF designed to return two times the daily return of the S&P 500. If the value of the S&P 500 increases by 1% in a day, then the value of this fund rises by roughly 2% after management fees are subtracted. But, if the S&P 500 loses 1% of its value in a day, then the ProShares Ultra S&P 500 ETF declines in value by about 2%.

The ProShares UltraShort S&P 500 ETF(SDS -1.32%) is an inverse leveraged ETF designed to return two times the opposite of the S&P 500's daily performance. If the S&P 500 loses 1% of value in a day, then this fund's value increases by 2%. A value increase of 2% for the S&P 500 results in a 4% value decrease for the ProShares UltraShort S&P 500 ETF.

Because the effects of leverage are compounded over time with leveraged ETFs, the long-term returns generated by these ETFs do not simply mirror the returns of the index or asset class they are designed to track. Periods of volatility can cause leveraged ETFs to severely underperform relative to the asset or index they track. As with the first example above, a triple-leveraged S&P 500 ETF loses 60% when the underlying index only loses 20%. In some rare cases, particularly when derivatives are used, a leveraged ETF can even lose all or most of its value.

Pros and Cons of leveraged ETFs

Pros and cons of leveraged ETFs

Leveraged ETFs are often used by traders making short-term investments. Imagine that a trader expects the price of oil to increase over the course of a few days or weeks. A small position in a leveraged ETF can greatly increase the trader's return if that prediction is correct. If a trader expects oil's short-term price to decline, then owning shares in an inverse leveraged ETF can provide a hedge against potential losses. But, if a trader wrongly predicts an outcome, then the leveraged nature of the ETF amplifies the trader's losses.

These are the main benefits and drawbacks of investing in a leveraged ETF:

Chart by author.
Benefits of Leveraged ETFsRisks of Leveraged ETFs
Leveraged ETFs amplify daily returns and can help traders generate outsized returns and hedge against potential losses.A leveraged ETF's amplified daily returns can trigger steep losses in short periods of time, and a leveraged ETF can lose most or all of its value.
Shares of leveraged ETFs are traded in the open market like a stock.Some leveraged ETFs are not heavily traded, meaning that your ability to buy or sell shares in a leveraged fund may be constrained.
Investing in a leveraged ETF can confer indirect exposure to derivatives contracts.Because they utilize derivatives to boost returns, leveraged ETFs are less likely to closely track the underlying index or asset.
Leveraged ETFs mirror the daily returns of an index or asset with minimal tracking errors.Leveraged ETFs over the long term do not closely mirror the daily returns of the index or asset they track.
How to Invest in ETFsExchange-traded funds let an investor buy lots of stocks and bonds at once.
How to Invest in Index FundsIndex funds track a particular index and can be a good way to invest. Get a fast introduction to index funds here.
How to Invest MoneyBefore you put down your hard-earned cash, consider your investment style.
Industries That Thrive During RecessionsSome industries do well when the economy goes south. Here's how to recession-proof your portfolio.

Should a long-term investor buy leveraged ETFs?

Should a long-term investor buy leveraged ETFs?

While leveraged ETFs can technically be held for long periods of time, The Motley Fool does not recommend doing so. The prospect of generating impressive returns in the short term might be tempting, but, in periods of economic decline, leveraged ETFs can lose significant value. Non-leveraged ETFs are a far better option for a long-term investor.

Nicholas Rossolillo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Leveraged ETF Ins and Outs for Long-Term Investing | The Motley Fool (2024)

FAQs

Leveraged ETF Ins and Outs for Long-Term Investing | The Motley Fool? ›

While leveraged ETFs can technically be held for long periods of time, The Motley Fool does not recommend doing so. The prospect of generating impressive returns in the short term might be tempting, but, in periods of economic decline, leveraged ETFs can lose significant value.

Should you invest in leveraged ETFs for long-term? ›

Nearly all leveraged ETFs come with a prominent warning in their prospectus: they are not designed for long-term holding. The combination of leverage, market volatility, and an unfavorable sequence of returns can lead to disastrous outcomes.

Why not invest in 3x leveraged ETF? ›

A leveraged ETF uses derivative contracts to magnify the daily gains of an index or benchmark. These funds can offer high returns, but they also come with high risk and expenses. Funds that offer 3x leverage are particularly risky because they require higher leverage to achieve their returns.

Can you lose more money than you invested in a leveraged ETF? ›

In other words, you could potentially be liable for more than you invested because you bought the position on leverage. But can a leveraged ETF go negative? No. If you own a leveraged ETF you can't lose more than your initial investment amount.

Why leveraged ETFs are not a long-term bet? ›

Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.

How long is too long to hold a leveraged ETF? ›

The daily rebalancing of leveraged and inverse ETFs creates a situation that for periods longer than a day or two the return of a leveraged or inverse ETF will deviate from the margin account benchmark.

Can 3x leveraged ETF go to zero? ›

Because they rebalance daily, leveraged ETFs usually never lose all of their value. They can, however, fall toward zero over time.

Can I lose all my money with leveraged ETFs? ›

Leveraged ETFs amplify daily returns and can help traders generate outsized returns and hedge against potential losses. A leveraged ETF's amplified daily returns can trigger steep losses in short periods of time, and a leveraged ETF can lose most or all of its value.

Why are 3X ETFs wealth destroyers? ›

The 3X ETFs use “total return swaps” to create the leverage. These swaps are settled each day. If the index (in this case, the Russell 1000 Financial Index) goes up consistently, then there's a good chance that the total return of the ETF will approximate 300% of the return on the index.

Do all leveraged ETFs go to zero? ›

Over even longer time horizons, every percentile (except the 100th) of the ETF's value will eventually converge to zero. This is not to say that rebalancing is always bad. Rebalancing a portfolio with positive expected growth will enhance median returns over time.

What are the pitfalls of leveraged ETFs? ›

Risks and disadvantages of leveraged ETFs
  • Speculative market risk. There is a heightened degree of market risk associated with levered ETFs. ...
  • Not the best choice for long-term Investments. ...
  • High fees. ...
  • Compounding and Volatility Exposure. ...
  • Catastrophic Losses.

Are concerns about leveraged ETFs overblown? ›

By some estimates, returns generate up to 74% less rebalancing by leveraged and inverse ETFs once capital flows are taken into account. As a consequence, the potential for these types of products to exacerbate volatility should be much lower than many claim.

Can I lose all my money in leverage trading? ›

While it can increase your potential profits, it can also lead to substantial losses, as you could wipe out your entire account balance if the market moves against you. Therefore, it's essential to use leverage trading wisely, with a full understanding of the risks involved.

What is the most volatile 3x ETF? ›

The Direxion Daily Junior Gold Miners Index Bull 3x Shares (JNUG) and the Direxion Daily Junior Gold Miners Index Bear 3x Shares (JDST) are the two most volatile exchange-traded funds of all. Each has a one-year volatility reading of about 170.

Can you hold Tqqq long term? ›

7 While the Nasdaq-100 is historically more volatile than the S&P 500, QQQ can be held over long time frames while its cousin, TQQQ is definitely a short-term trade.

Can you hold Sqqq long term? ›

Disadvantages of the UltraPro Short QQQ (SQQQ) ETF

This fund is unsuitable for a long-term hold; investors who buy and hold SQQQ find their returns badly damaged by expenses and decay. Several key factors prevent SQQQ from serving as an acceptable core holding in an investor's portfolio.

Is a leveraged ETF worth it? ›

We found that leveraged ETFs in three out of the four categories provide sufficient returns over the long run to justify their costs and risks, and despite persistent tracking-error divergence. We began our research by pulling data on all leveraged ETFs that have been issued in U.S. markets over the past 10 years.

Can I use leverage for long term? ›

They said, “Leveraged ETFs are not suitable for long-term buy and hold.”

Can you hold qqq long term? ›

7 While the Nasdaq-100 is historically more volatile than the S&P 500, QQQ can be held over long time frames while its cousin, TQQQ is definitely a short-term trade.

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