The esoteric flavour of ETFs could be more than most retail investors could stomach
When ETFs gained traction among investors, it didn’t take long for the space to become so saturated with index-based funds that they took on an unflattering nickname: plain-vanilla ETFs. That was the cue for providers to experiment with new and exciting flavours, like smart-beta, multi-factor ETFs — and leveraged ETFs.
While leveraged ETFs may promise investors supercharged returns, they also “make big promises they cannot keep simply because of the way they are designed,” according to a recent piece on Kiplinger.
Leveraged ETFs deliver a multiple of their underlying index’s returns each day. When a leveraged fund’s index goes up by 0.5%, for example, the fund will rise by 1%. In contrast, a non-leveraged fund that follows the same index will go up by only 0.5%.
The problem arises when you consider two ETFs — one leveraged, one non-leveraged — that follow the same index and start off at $50. If the regular ETF goes down by one point to $49 per share, incurring a 2% loss, the leveraged ETF will dip twice as much, losing 4% to settle at $48.
“On the second day, the regular ETF rallies back one point to $50,” the report said. “The math says that the regular ETF gained 2.04%. Therefore, the 2x ETF gained 4.08% … [which] results in a price of $49.96.”
Because of the outsized effects of losses, leveraged ETFs can lose money over time even if the underlying fund stays within a flat trading range. That means they’re not suited for buy-and-hold strategies.
“And the same is true for inverse leveraged ETFs, which are designed to move two or three times the daily change in the underlying but in the opposite direction,” the report said. “Making them even less attractive, the higher the volatility of the underlying market, the worse the capital decay becomes.”
Given the natural value decay of leveraged ETFs, it’s theoretically possible to short both the leveraged and the inverse leveraged versions of an ETF and reap a profit. However, since volatility is expected to return to markets, a shorting strategy like this would be extremely risky.
“They can be appropriate for experienced traders who already understand the power of leverage and the time-decay factors involved,” the report said. “If you time them right, a quick trade can be lucrative. But most of us should leave them alone.”