Leveraged ETFs: Reward Isn’t Free!
Last week, I was interviewed by Mike Khouw of CNBC who has his own channel on YouTube (Open Interest). Most of it was about my latest blog on VIX futures and what they may be signaling for volatility and the market in general. At the end of the interview, one viewer asked a question about leveraged ETF’s that caught my attention (you can read it at the bottom of the screenshot below):
Good question! To the uninitiated, leveraged ETF’s are just like regular ETF’s but have been supercharged to deliver higher returns than that of the benchmark index. In the case of a traditional ETF, the fund seeks to match the performance of its index on a 1:1 basis. In a leveraged ETF, the fund is designed to produce some ratio of its normal, 1:1 return. In the example above, the viewer is asking about SPY funds that are designed to return 3 times the performance of the SPX index (in this case SPXL, the Direxion Daily S&P500 Bull 3X Shares ETF). Higher or lower ratio leveraged ETFs also exist, on a variety of indexes and single stocks, as well as “inverse” funds that pay off if the index declines, are also available. Never underestimate the ability of Wall Street to invent new products!
One very important point about leveraged ETFs that often escapes notice: the funds are not designed, nor guaranteed, to produce the stated higher returns for anything longer than a single day. In the case of one of the most popular leveraged funds, TQQQ, its daily investment objective is 3 times the performance of the Nasdaq-100 (i.e., QQQ); anything longer term will diverge significantly. This was a such a source of investor misunderstanding that the SEC issued an Investor Bulletin in 2023 to clarify the matter.
Why does daily performance vary from that of the longer-term? The answer goes to the heart of the viewer’s question. Leveraged ETFs suffer from a phenomenon termed “volatility drag,” or sometimes “volatility decay.” Confusingly, these have nothing to do with options volatility, but everything to do with leverage and compounding.
Stay with me. Suppose a hypothetical index starts at 100 on day one, drops to 90 (a 10% loss) on day 2, and then recovers back to 100 (11.1% gain) on day three. Over the three days, the index was unchanged. However, a 3X ETF would amplify each daily move by 3: 30% down on day two (index moves down to 70), and a 33.3% gain on day three (index backup to 93.31). After all this, the index would wind up 6.69% lower from its start at 100, despite the fact that it was unchanged over the period.
During severe market turmoil, and since each daily move is amplified, this can cause losses much more significant than the benchmark incurred. Adding to an already bad situation, leveraged fund managers must rebalance, increasing or decreasing their exposure as the market changes. This can force them to buy into expensive markets, and vice versa. It also assumes that there is sufficient liquidity to do so, which is not necessarily the case for some single stock leveraged ETFs. And finally, since markets are inconsistent from day-to-day, this can lead to high expense loads.
Of course, the opposite effect would occur if the market increased, but the market must increase consistently to outperform the underlying index at the levered ratio. In any case, leverage magnifies each swing, causing the return divergence. What you are left with is higher volatility, roughly by the stated daily leverage ratio (3x in the above example). Since returns will not approach 3X on anything other than a daily basis, the risk-adjusted returns of leveraged ETFs suffer accordingly (i.e., the higher return does not compensate adequately for the higher volatility).
Equity markets haven’t seen a prolonged bear market since 2022, and I suspect that is leading some investors to underestimate the risk of leveraged ETFs. During serious downturns, such as during the start of the pandemic or during the tariff panic last April, leveraged ETFs can suffer from eye-watering declines. Coupled with extremely high fees (some over 100 bps, and btw, it has been shown that fees are an excellent indicator of fund performance), leveraged ETFs don’t seem to be a suitable product for most medium to long-term investors. However, if you’re very bullish or bearish, and want to day trade, leveraged ETFs may be a simple way to gain extra performance.
Something to Worry About?
Since late-2021, long term government bond yields in major European economies (UK, France, the Netherlands, and Germany) have been rising. Most recently, a combination of inflationary fears, increasing debt levels, and budget deficits have conspired to propel them to their highest levels in over a decade. Promises of increased military spending have only added to the situation.
The market is skeptical that any of these governments can get their deficits under control. A vicious circle could then result – higher debt pushes yields higher, which worsens their deficits by increasing debt service, which then pushes yields even higher. In developing economies, a debt crisis and massive loss of confidence then results, similar to what Greece experienced from 2009 – 2018.
Currently, the UK and France are the most obvious candidates for some degree of turmoil, and whether their governments have the will, or even the power, to undergo spending cuts or increased taxes is anyone’s guess. Historically, the pain is usually kicked down the road for some other government to deal with. That is, until the markets – the bond vigilantes – gang up to restore confidence and force difficult decisions.
Is that really going to happen? Frankly, I doubt it. Some European governments may fall and be replaced by new, more hardline versions, and then some combination of new policy and half measures will serve to reassure the markets. That is, until the next time. Whether the Europeans (and the US, for that matter) want to acknowledge it or not, the combination of slow growth, increased defense spending, and an ever-increasing social safety net is unsustainable. Eventually, if governments don’t deal with it, the markets will.