Leveraged ETFs: Consider The Risks

Leveraged investment products, like the notorious triple leveraged index ETFs, have increased in popularity among traders who may not have the funds to participate in full sized SPX contracts or /ES futures which have plenty of leverage inherently. These derivatives promise magnified profits when the market moves in the levered direction. However, the same levered products that offer thrilling potential upside are equally capable of delivering complete losses. Due to the nature of constant rebalancing these products really should not be used for anything longer than a short-term trade.

How Leveraged Investment Products Work

Leveraged ETFs, the most common type of leveraged investment product, aim to deliver returns that correspond to a multiple of the daily return of an underlying index. For instance, a 2x leveraged ETF should provide twice the daily return of its benchmark. If the index it tracks rises by 1% during a trading day, the 2x leveraged ETF is designed to gain 2%. While this multiplication effect is enticing, it’s vital to recognize the fine print: these products are crafted to achieve this target on a daily basis.

The mechanic employed to get a roughly 2x or 3x return comes from using a blend of swaps, options, and futures, rebalanced on a daily basis to ensure the correct amount of exposure. It is up to the ETF manager to outline in their prospectus when the fund is rebalanced, and how it is rebalanced.

The Risks of Holding Leveraged Products Long-Term

Leveraged investment products are not suitable for extended holds. One of the most significant risks is related to the daily rebalancing process to achieve the results mentioned above. The compounding nature of leveraged ETFs can lead to value decay over time. Suppose you have a 2x leveraged ETF tracking a particular index, and that index experiences daily returns of +2% and -2% on consecutive trading days. The result, surprisingly, is not a net zero return. Due to the daily rebalancing, the 2x leveraged ETF will incur a loss over those two days and not remain “flat.” These products are engineered for short-term trading and are optimized for achieving their daily objectives. Holding them for an extended period, especially in volatile markets, can lead to unintended and detrimental outcomes. To fully understand the ETF’s risks you should always read their prospectus.

The Impact of Rebalancing on Technical Analysis

When trading leveraged investment products, understand that the daily rebalancing introduces a unique challenge for technical analysis. Because analysts rely on a clear view of price action the rebalance destroys price patterns, support and resistance levels, and various other technical techniques.

A leveraged ETF’s price is heavily influenced by intraday volatility, creating a phenomenon where prices may not follow the usual patterns seen in the underlying non-leveraged assets. Many traders prefer to conduct their technical analysis on the non-leveraged underlying ETF or asset and apply their bias to the proper leveraged ETF. This approach allows for a more consistent and reliable technical analysis, unburdened by the daily price fluctuations caused by rebalancing. By focusing on the underlying asset’s chart, traders can get a clearer picture of long-term trends, support and resistance levels, and potential reversal patterns.

The Mirage of Long-Term Returns

Leveraged ETFs are designed for daily trading, not long-term investments. The most common misconception here is thinking that you can short a bearish leveraged ETF and hold long dated positions since the chart is constantly moving in the downward direction. Understand that the longer you hold the position, the more the daily rebalance decays any profit that you would have made. Its very difficult to actually turn this into a profitable strategy. The more leverage there is, the more the decay is amplified as well. For example the 3x bear ETFs decay more rapidly than the 2x bear ETFs.

Conclusion

Leveraged investment products are a powerful tool for day traders and short-term speculators who understand the risks of daily rebalancing and have a firm grasp of market behavior. For long-term investors, especially those aiming to hold these products for more than a day, it’s likely not a product that fits into your strategy. They are highly complex, and their performance can deviate significantly from what an investor might expect in direct comparison to the underlying. While they can provide substantial returns in the short term, the risks of holding them for more extended periods far outweigh the rewards.