Exchange Traded Funds (ETFs) have been under scrutiny for quite a while now for their performances during periods of high market volatility and deviations from the underlying assets value. Leveraged ETFs are no exception and probably among the most misunderstood financial products. Leveraged ETFs were first launched in 2006 and since then the market for this kind of financial products has grown reaching a total of $50.9 million assets, with more than 275 leveraged ETFs trading on exchanges in 2013. The Financial Industry Regulatory Authority (FINRA) has warned investors about the potential pitfalls of leveraged ETFs and in some cases it has punished banks. On the other hand, investment banks like UBS and brokerage firms like Ameriprise stopped offering leveraged ETFs to their clients.

Leveraged ETFs goal is to delivery twice or three times the daily return on a specific underlying index. In order to do so, they have to re-balance their portfolios on a daily basis and keep the proper amount of leverage in order to make sure they deliver exactly twice or three times the daily return on the index. As a consequence, leveraged ETFs are exposed to price erosion: an investor would have to borrow more funds to buy more ETFs as the price of the index goes up. Conversely, the investor would need to buy less ETFs as the price goes down.

Let’s see this with an example. For the sake of simplicity, I assume that the price on the underlying index goes up at Tn and down at Tn+1 by 10%. An investor starts with $100 at day n and wants to invest in a 2X Leveraged ETF. It would have to borrow $100 to invest $200. Assume the market goes up by 10%. The investor makes $220, repays the $100 it borrowed and retains $120. At day Tn+1, the investor would have to borrow $120 to invest $240 in the leveraged ETF. Assume now that prices go down by 10%. The investor loses $24 but still makes $216. It repays the $120 it borrowed at day n and retains only $96. Again at day Tn+2, the investor would have to borrow $96 to invest $192 in the ETF. Prices go up by 10% and the investor makes $211.2. It repays the $96 it borrowed at day Tn+1 retaining $115.2. And so on and so forth.

The effects of a relatively “long-term” investment in a leveraged ETF look like this:

Natural decay for a 2X and 3X Leveraged ETF Volatility window -10%/+10%

As we increase the volatility window from ±10% to ± 20% (that is, prices go up and down by 20%), the exponential decay is even more magnified:

Natural decay for a 2X and 3X Leveraged ETF Volatility window -20%/+20%

It seems clear that the daily compounding is amplified as markets experience periods of high volatility. The higher the volatility, the more adversely affected is the leveraged ETF. In addition, expenses are high as leveraged ETFs require active portfolio management. The most popular leveraged ETF (ProShares Ultra S&P 500) has expenses of approximately 0.9% while “vanilla” ETFs without leverage cost 0.1% or less. Price erosion is even more accentuated in the 3X leveraged ETF because of the expenses, which are even higher than in the 2X as portfolio management is more challenging.

Leveraged ETFs should be seen as extremely short-term bets on specific market moves or as a way to hedge some specific market exposure: therefore as mere investment vehicles. On the long-term, leveraged ETFs do not replicate the underlying index. Big deviations from it are expected.

The lesson here is a lesson on leverage. Passive investors should avoid building long-term strategies using leveraged ETFs. They are more suited for institutional investors who are primarily engaged on active trading.

Got a comment or question? Feel free to contact Cullen via email here or on Twitter here.

3A%2F%2F1.gravatar.com%2Favatar%2Fad516503a11cd5ca435acc9bb6523536%3Fs%3D179&r=G /%