Leveraged ETF Investing (How Not To…)
We are huge proponents not just of ETF’s, but of the best investments for your (or any investors) situation. Sometimes ETF’s are best, sometimes regular old mutual funds are best. Leveraged ETF investing however is never the best!
The use of leveraged ETF’s can never be a great alternative because by their nature they can’t be used over long periods of time successfully (aside from pure luck, but you’d be better off betting on black or red). Leveraged ETF’s are short term “gambling like” investments. We’re not short term investors, and as such we never recommend leveraged ETF’s.
Leveraged ETF’s are exchange traded funds which seek to deliver a return multiple times that of the underlying index. For example a 2X ETF would seek to give you twice the upside of an index. If the S&P 500 was up 2% on a particular day, you’d hope the 2X S&P 500 ETF was up 4% that same day. If you invested $1,000 in the S&P 500 ETF you’d have $1,020. Likewise with the 2X S&P 500 ETF you’d hope to have $1,040.
It doesn’t quite work like this all the time because of rebalancing. Suppose you run a 60mm leveraged ETF designed to mimic twice the exposure of the Russell 2000. You now control 120mm worth of assets that look just like the Russell 2000, with only 60mm of investor funds. Leveraged ETF investing achieves this multiplication affect through use of derivatives, such as call or put options, equity swaps, etc.
If the Russell 2000 increases by 2% today, the 120mm you control increases by 2.4mm to $122,400,000. So you made 2.4mm on your 60mm portfolio – that’s a 4% return when the Russell 2000 went up by only 2%. Pretty good right?
Of course we didn’t take any taxes or expenses into consideration. Those factors really reduce your returns.
In an up market this sounds pretty great right? But when do the markets go up every day?
In a sideways volatile or downwards market things get a little nasty. Let’s assume the index trades at 100:
|Day||Index Open||Index Close||Index Return||ETF Open||ETF Close||ETF Return|
So above you have a flat week for the index. The leveraged ETF however ended up .20% underwater. This doesn’t seem like much, but over time it adds up to large amounts.
Russell 2000 2x Strategy – Leveraged ETF Investing in Small Caps
Here’s a great example I stumbled on which clearly shows that leveraged ETF’s can be disastrous for your financial health because:
- They are ONLY meant for short term trading activities which is just plain dumb, and
- They don’t work well for long term holding strategies
Take a look for yourself:
You can see clearly that the Russell 2000 was down just about 4% in 2011. That shouldn’t surprise anyone. But you can also see that the 2x leveraged ETF which mimics the Russell 2000 was down almost 4 times as much to nearly -20%! That’s amazing!
The average ETF investor would assume that if the Russell 2000 was down 4% the 2X leveraged ETF would have ended up -8%. Clearly because of the rebalancing effects that is not the case.
We haven’t even touched on fees and expenses. The internal expense ratios on leveraged ETF’s are usually quite high – 1% or more! Not to mention the trading costs within the portfolio (trading derivatives isn’t cheap necessarily) can be substantial, and the tax ramifications can also detract from your investment returns.
Avoid Leveraged ETF Investing
If you’re a gambler – go for it! Just don’t put any more money than you can afford to lose in leveraged ETF’s. If you’re a long term investor – run for cover! Leveraged ETF’s aren’t for you OR your investment portfolio!
By Greg Phelps