Best Of 2020: Don't Buy & Hold Leveraged ETFs

Seriously, don't. Please.    

[Editor's Note: This article originally appeared on March 18, 2020.

Since I wrote "Why These Leveraged Energy ETPs Tanked" last week, I've had several readers reach out to me about the funds I mentioned in the story, wondering if now is the right time to snatch these ETFs up on the cheap and hold them until they once again go sky-high.

Indeed, the flows data indicates a lot of folks may be doing just that. In particular, the VelocityShares 3x Long Crude Oil ETN (UWT) saw a massive influx of cash last week, to the tune of half a billion dollars:

Source: ETF.com. Data as of March 17, 2020.

In case I didn't make it obvious enough last week, let me be crystal clear now.

Stop doing this.

More explicitly: Stop buying triple-leveraged ETFs like UWT and holding on to them in the hope that when the underlying securities do pop, you'll reap triple the benefits. That's not how these products work. You will be burned, and it will happen sooner rather than later.

Leveraged ETFs Don't Behave How You Expect

A common assumption is that a leveraged or inverse ETP offers some multiplier of the total return of an index; that is to say, a 3x S&P 500 ETF will provide you triple the returns of the S&P 500 Index. Intuitively, that just seems to make sense.

But your intuition is wrong.

Leveraged and inverse ETPs instead offer some multiplier of the daily return of their underlying index; meaning, that a 3x S&P 500 ETF will provide triple whatever the daily return of the S&P 500 Index is, only for the leverage factor to reset the following day. Effectively, the slate is wiped clean. (Read: "ETF Education: The Problem With Inverse/Leveraged ETFs.")

Multiplying daily vs. total returns may sound like a subtle difference, but it's one that leads to wildly different math. For starters, even a non-leveraged fund that falls 10% in one day can't make it back up with a simple 10% increase the following day. A $100 share that falls 10% in one day is worth $90 at the end of the day. But if its price goes up 10% on the second day, that’s a 10% increase from $90, putting the price at $99. There’s an erosion that occurs with a daily reset, and when a fund is leveraged, that erosion is magnified.  

Returns Diverge Quicker Than You'd Think

Here's a hypothetical example of a 3x leveraged ETN, with an index starting value of $100 and an ETF starting level of $100:

Source: ETF.com

Let's say that at the end of Day 1, the underlying index has gone down 10%. That means the index closes at $90, while the ETF closes at $70. So far, so good, right?

Then let's say that on Day 2, there's a 15% rebound. The index then closes at $103.50, which is 3.5% up from where it started.

Given that, you might assume that the 3x ETF would close at $110.50, or 10.5% up from its starting value—that is to say, three times that two-day total return of the index of 3.5%.

But the ETF actually closes at $101.50, or only 1.5% up from its starting point. That's because the leveraged ETF has added 3x 15%, which, again, was the daily return of the underlying index.

Compounding Makes Big Drops Bigger

Now let's say that on Day 3, our hypothetical index drops 5%. That would put its closing value at $98.33, which is, all told, 1.7% down from its starting value.

You might assume one of two things: either 1) our ETF will come right back to $100, since just adding up the net index changes over the three days equals 0%; or 2) that our ETF will close at $94.90, which is to say, three times the three-day total return of the index of -1.7%.

However, both assumptions are incorrect. The leveraged ETF will actually drop to $86.28, which is 3 x -5%, where 5% is the daily return of the index. Overall, over the three-day period the ETF has dropped 13.7%!

Look, I get it. This math is confusing. Through the magic of compounding and path dependence, it doesn't work out how you'd expect. (Also, keep in mind that this is an extremely simplified calculation, one that doesn't take into account expense ratios, interest accrued from Treasury holdings, trading costs and so on.) (Read: "The Truth About Leveraged ETF Returns.")

But math doesn't lie.

Leveraged ETPs Are Not For You

There's nothing wrong with leveraged and inverse ETPs held by the right hands. They're great instruments for institutions and traders who need ultra-short-term hedging instruments and risk management tools.

However, these products were really designed only for this audience, not for retail investors like you and me. But it's just not possible to wall off certain types of ETFs for only certain types of investors, like it is with institutional classes of mutual funds. Neither can a fund require a minimum investment to price out retail investors.

So it's up to the retail investor to realize that even though leveraged and inverse ETPs are available to you, they're not for you.

It doesn't matter whether you're looking to save for your retirement, or maybe just make a quick buck. I'm begging you: Leave these products for the sophisticated traders they were meant for.

And if you don't believe me, do the math yourself.

Contact Lara Crigger at [email protected]