Investors all have the same goal in mind: to put money in the market so it can work for them, yielding as high of a return on investment as possible. It’s this general concept that makes leveraged exchange-traded funds (ETFs) so interesting.
Leveraged ETFs are marketed as a type of exchange-traded fund investment that can return what a normal ETF would return in multiples. However, this type of investment can be incredibly dangerous because of how these leveraged returns are created and the risks associated with being wrong.
Despite their serious risks and poor long-term prospects, in some cases, leveraged ETFs have their place in the portfolios of a certain (small) group of investors. Read on to learn if you’re part of that group.
What Is a Leveraged ETF?
Before you can understand what a leveraged ETF is, it’s important that you understand ETFs in general. ETFs are bucket investments that track the movement within an entire index or sector. All major stock indexes such as the NASDAQ, DJIA, and NYSE have their own ETF that’s designed to track their movements.
When investing in ETFs, you’re not investing in a single stock. Instead, you’re essentially investing in the entire index. So, if you invest in an S&P 500 ETF, you’re betting on all 500 companies listed on the S&P 500 at the same time.
ETFs allow investors to avoid the headache of choosing single stocks for their portfolio and provide the ultimate diversification through a single investment vehicle. On the other hand, if you invest in an ETF, you’ll never beat the gains posted by the benchmark. If the S&P 500 gains 1% and you own an S&P 500 ETF, you’ve earned 1%.
Leveraged ETFs are different in that they promise multiples on the returns on the index they’re named after. So, if you have a leveraged S&P 500 ETF and the S&P gains 1%, you may see gains of 2% or 3%. These additional gains are created through derivatives and debt that multiply the returns of the underlying index.
There are also inverse ETFs, which use derivative investment vehicles to move in the opposite direction of an underlying asset. So, instead of multiplying gains or losses, inverse ETFs will experience one, two, or three times the movement in the opposite direction as the underlying asset, rising big when prices fall and falling big when prices rise. It all sounds great until you get into the details.
Pro tip: If you’re thinking about adding leveraged ETFs to your portfolio, they can be bought through an online broker like Robinhood. If you don’t have a Robinhood account, you’ll receive a free share of stock after signing up.
How Leveraged ETFs Multiply Index Returns
To create leveraged ETFs, derivative investments are made, loans are taken out, or a combination of the two takes place in order to amplify the gains of the underlying index. This is most commonly done in one of three ways:
- Options Contracts. Options contracts are contracts between the buyer and seller that give the buyer the right to buy shares of a stock at a later date for a predetermined price. An option that bets on price gains is known as a call option, while an option that bets on declines is known as a put option. Options come with high fees but give investors exposure to stocks with a much lower initial investment than traditional investing.
- Margin. An easier way to understand margin is to call it a debt. An investor that invests on margin borrows money from their broker to increase their stake in a stock they are purchasing. This often gives the investor the ability to buy two, three, or more times the amount of stock with the same initial investment. Again, these transactions will come with high fees. Brokers charge as high as 3% on these short-term loans, which can dig into profits in a big way.
- A Mix Between Options and Margin Trading. Some leveraged ETFs will use a mix of options and margins to offer multiples on the returns of their underlying index.
Everything in Leveraged ETFs is Good — Until it Goes Bad
With options and margins being used by expert investors to multiply the returns on your investment, the concept sounds incredible. That is, until one of these expert investors gets it wrong.
Sadly, there has never been an investor that makes the right moves 100% of the time. Even legendary investor Warren Buffett has earned his share of losses from bad investment choices.
When leveraged ETFs go south, they go south very quickly.
That’s because, just as leverage allows for gains to multiply, it creates multiples of losses when an investment goes wrong. So, instead of looking at two or three times the gains realized by the underlying index, investments that go wrong end up with more than two to three times the losses.
Not only is the investor going to lose two or three times the amount they would have lost in a standard ETF, but the investor is also out an additional 1% to 3% on average due to the cost of the leverage that expanded their losses.
To put that into perspective, let’s say that the S&P 500 has a bad day, declining 3%, and you have shares in an S&P 500 ETF that’s leveraged three times. In this case, your loss for the day would be three times the S&P 500’s loss, which comes to 9% — plus an additional 1% to 3% for the cost of the options and margin trades that enabled the leverage.
In this case, you would have turned a 3% loss into a loss of anywhere from 10% to 12%.
The Short-Term Nature of Leveraged ETFs Compounds the Risks
No matter what type of prediction you make, the longer the time you have for that prediction to come true, the stronger your chance of being correct.
Think of this in terms of weather. If you were to predict that it would rain in the Mojave Desert tomorrow, the smart bet would be against your prediction. It’s a desert. Rain is a rare occurrence, making the chances of rain in the Mojave tomorrow slim-to-none.
On the other hand, if you were to predict that it would rain in the Mojave Desert sometime over the next year, there’s a strong chance that you’ll be correct. According to Sciencing, the Mojave Desert experiences around five inches of rain on an annual basis. So, while it doesn’t rain often, rain does happen, and should you give it time, you’ll be correct in predicting that it will.
This is the same in the stock market. Throughout history, all of the major indexes have seen strong gains. There have been times that they have seen tremendous declines as well. Economic depressions, recessions, and market corrections all lead to short-term losses, but as their name suggests, these losses are short-term.
Holding onto the right standard ETF for an extended period of time doesn’t necessarily guarantee that you will earn a profit, but it increases your chances of doing so dramatically. Unfortunately, leveraged ETFs don’t work in the same way.
The exorbitant fees for the use of derivative investments and debt used to compound gains in leveraged ETFs lead to diminishing returns. In many cases, leveraged ETFs show sustained losses from inception, regardless of the index they’re based on.
Although this isn’t always the case for all leveraged ETFs, it does outline the dangers associated with this investment vehicle. Positive-direction leveraged ETFs generally have positive long-run gains, especially over long bull runs. Other leveraged ETFs like leveraged inverse ETFs and volatility leveraged ETFs tend to decline dramatically over time. As with choosing stocks correctly, choosing the right leveraged ETFs is crucial because the leverage can create outsized — even near-total — losses.
An example of this is the Direxion Daily Gold Miners Index Bull Leveraged 2X ETF, trading with the ticker NUGT. This fund seeks daily investment results, before fees and expenses, of 200% of the daily performance of the NYSE Arca Gold Miners Index.
Take a look at the fund’s price chart since its inception in 2011:
(Chart courtesy of Yahoo! Finance)
As you can see, the fund has done well in the short term at times, especially in its beginning years. The problems happen when you take a long-term view. The underlying index fell substantially during 2012 and 2013, and the leveraged fund’s value declined more than twice as much in that time.
Doing the math from its starting point of $78,540.00 (considering all reverse splits) to its current value of $67.32 shows that since inception, this leveraged ETF has lost approximately 99.9% of its value.
Unfortunately, the same pattern can be seen in many leveraged ETFs over the long term. Moderate downturns in the underlying index can quickly become near-total wipeouts when multiplied by leverage.
Who Should Invest in Leveraged ETFs
There is a small group of investors who should consider leveraged ETFs. This type of investment is definitely not for the beginner investor, and many expert investors shy away as well. The investor who might be interested in using leveraged ETFs as an investment vehicle has the following qualities:
- An Extremely Healthy Appetite for Risk. If there’s anything that you should take from this article, it’s that leveraged ETFs are some of the riskiest investments you can make. Due to the short-term nature of these investments and the potential for multiplied losses, the investor that sees leveraged ETFs as an opportunity is one who is OK with taking on this risk.
- The Desire to Make Short-Term Investments. Short-term investing is also known as active investing. Most investors want to buy stock and hold it for a long period of time, checking in on how their investments are doing on a quarterly basis. With leveraged ETFs, you wouldn’t want to hold onto them for long. So, this type of investment requires daily attention.
- The Experience to Know When to Hold ’Em and When to Fold ’Em. Investing is an emotional process and human beings are emotional creatures. It takes experience to know how to put those emotions aside and make the right moves at the right time. The investor with enough experience to trade in leveraged ETFs shouldn’t allow greed to get in the way when prices are going up, nor fear of loss to expand your losses further when prices go down. This extreme discipline is required to be successful in the trading of leveraged ETFs.
Moreover, those who invest in leveraged ETFs rarely use these in 100% of their investment portfolio. The idea behind these types of investments is to use a small portion of your investing funds in a high-risk/high-reward way to expand your overall gains.
Even if you are OK with losses, have the time to play the short-term investing game, and have the experience you need to set your emotions aside and make logical trades, it’s never a good idea to put more than 10% of your overall investing power into high-risk investments like leveraged ETFs.
The Best Time to Use Leveraged ETFs
If you believe that you possess the qualities mentioned above and you’d like to give leveraged ETF investing a try, keep in mind that timing is everything. Always remember, you don’t want to hold onto these investments for very long.
Leveraged ETFs are best used in times of high levels of speculation. Investors who took advantage of tech-based leveraged ETFs during the dot-com bubble and investors in real estate ETFs during the real estate bubble benefited greatly by making wise use of this investment vehicle. Any time a bubble takes place, leveraged ETFs have the potential to greatly expand gains.
During these times, the values of shares will usually rise dramatically. Of course, buying in on lows and selling at highs during this time can produce incredible returns, especially in the case of leveraged ETFs.
Rules for Leveraged ETF Investing
If you do decide to invest in leveraged ETFs, hold yourself to the following rules:
- Set Aside a Budget and Stick to It. Never put all of your money into leveraged ETFs. Doing so will likely lead to substantial losses. Instead, set a particular budget that you will use to try your hand with this investment vehicle. Make sure it’s not more than 10% of your investing budget to minimize the risks to your portfolio as a whole.
- Don’t Chase the ETF Down. When investing in leveraged ETFs, you have to know when to accept losses. Oftentimes, beginners will buy more as the ETF drops, hoping for a bounce-back. This will end badly. If a trade is a loss, it’s never fun, but it’s best to take the loss and move on.
- Only Bet What You Can Afford to Lose. If you’re going to invest in leveraged ETFs, go in with the mindset that you will lose your entire investment at the end. In doing so, you’ll never put up more money than you are OK with losing.
- Do Your Research. Before investing in any leveraged ETF, take the time to do your research and understand what you’re getting yourself into. You need a good understanding of the underlying assets including any margins or options. It’s also important to pay close attention to the fees associated with leveraged ETFs, as they will lead to diminished returns and expanded losses.
The risks involved in leveraged ETFs can’t be stressed enough. All too often, beginners get sucked in with the allure of multiplied gains in comparison to standard ETFs. Not knowing much about the market and allowing their emotions to take hold, these beginners often chase losses or fail to sell when gains are available, leading to losses. If you’re not an expert investor, this is not the type of investment for you.
If you are an expert investor, and you haven’t used leveraged ETFs yet, it’s worthwhile to dig in and see if they are for you. As with any investment vehicle, leveraged ETFs have their time and place, even if those times may be few and far between. However, if you make the right moves with this type of investment, the rewards can be incredible.