Why Do Leveraged ETFs Decay?

Protect your portfolio and learn how decay can erode long-term returns.

While leveraged ETFs can offer significant upside potential, they also come with a unique set of risks, including the potential for decay. In this article, we’ll explore why leveraged ETFs decay and what investors need to know to protect their portfolios. 

What Is a Leveraged ETF? 

Leveraged ETFs are exchange-traded funds that allow investors to amplify their returns through the use of financial leverage. These funds typically use derivatives, such as options and futures contracts, to achieve a leverage ratio of two or three times the daily performance of a specific index or benchmark.

What Is Leveraged ETF Decay? 

It's important to understand what is meant by “decay” in the context of leveraged ETFs. When we say that a leveraged ETF decays, we mean that its returns can diverge significantly from what we might expect based on the performance of the underlying index.

For example, if the underlying index goes up by 1%, we might expect a leveraged ETF that seeks to deliver two times the daily return to go up by 2%. However, due to the effects of decay, the actual return might be less than 2%. 

Why Do Leveraged ETFs Decay? 

Leveraged ETFs decay due to the compounding effect of daily returns, also known as "volatility drag." This means that the returns of the ETFs may not match the returns of the underlying asset over longer periods.

The reason for this is that the leveraged ETF is designed to provide multiple returns of the underlying asset on a daily basis. The compounding effect of daily returns means that losses in the ETF are magnified over time. If the underlying asset experiences high volatility, the volatility drag will be more significant, resulting in higher losses for the leveraged ETF. 

Since leveraged ETFs require added layers of management and specialized trading strategies, investors should also be aware that there are associated costs that can be passed on to investors. 

In summary, there are three primary factors that contribute to leveraged ETF decay: compounding, volatility and the cost of leverage.

Compounding 

Leveraged ETFs use financial leverage to achieve their desired level of exposure to the underlying index. This means that they borrow money to invest in derivatives that deliver two or three times the daily return of the index. The returns from these investments are then combined with the ETF’s own assets to deliver the leveraged return. 

The problem with this approach is that it introduces compounding into the equation. Compounding occurs when the returns from an investment are reinvested, leading to exponential growth over time. In the case of leveraged ETFs, compounding can work against investors when the ETF’s returns are negative. Here’s why ... 

When the underlying index experiences a loss, the leveraged ETF will also experience a loss. Let’s say, for example, that the index goes down by 10% on day one. If we assume that the leveraged ETF seeks to deliver two times the daily return, we might expect the ETF to go down by 20% on day one. However, because the ETF’s assets have been leveraged, its actual loss might be greater than 20%. 

Now, let’s consider what happens on day two. If the index goes up by 10%, we might expect the leveraged ETF to go up by 20%. However, because the ETF’s starting value is now lower than it was on day one, the actual return might be less than 20%. In fact, it might take a return of more than 25% just to get back to the starting value! 

This example illustrates the impact of compounding on leveraged ETFs. When returns are negative, the ETF’s losses can be amplified by the leverage, leading to a larger starting value for the next day’s return. This can make it difficult for the ETF to recover even if the index subsequently experiences gains. 

Volatility 

The second factor that contributes to leveraged ETF decay is volatility. Volatility refers to the degree to which the price of an investment security fluctuates over time. In the case of leveraged ETFs, volatility can be particularly problematic because the ETF’s leverage ratio is based on the daily performance of the underlying index. 

Leveraged ETFs are designed to provide multiple returns of the underlying asset on a daily basis. This means that the ETF will provide returns that are a multiple of the daily returns of the underlying asset. For example, a 2x leveraged ETF will provide twice the daily return of the underlying asset.

Example

To understand how volatility contributes to decay in a leveraged ETF, let's take an example. Suppose an investor invests $100 in a 2x leveraged ETF that tracks the S&P 500 index. On the first day, the S&P 500 index goes up by 1%, and the ETF provides a return of 2%, resulting in a value of $102 for the investment.

On the second day, the S&P 500 index goes down by 2%, and the ETF provides a return of -4%, resulting in a value of $97.92 for the investment. Over two days, the S&P 500 index has gone down by 1%, but the leveraged ETF has lost more than 2% due to the compounding effect of daily returns. 

In a volatile market, where the underlying asset experiences large daily swings, the compounding effect of daily returns can cause the leveraged ETF to lose value rapidly. This is because losses are magnified over time, and gains are not enough to offset the losses. 

The Cost of Leverage 

Another factor that contributes to the decay of leveraged ETFs is the cost of leverage. Leveraged ETFs use various financial instruments such as futures, options and swaps to achieve their leverage. These instruments have associated costs, including transaction costs, bid/ask spreads and management fees. These costs can eat into the returns of the ETF and contribute to its decay. 

Higher volatility associated with leveraged ETFs can also add to the transaction costs and bid/ask spreads, which can further erode the returns of the ETF and contribute to its decay. 

Bottom Line on Leveraged ETFs

Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments. Investors should carefully consider the risks and costs associated with leveraged ETFs before investing in them.