Are leveraged ETFs safe long-term?
Nearly all leveraged ETFs come with a prominent warning in their prospectus: they are not designed for long-term holding. The combination of leverage, market volatility, and an unfavorable sequence of returns can lead to disastrous outcomes.
Using leverage also allows you to access more expensive investment options that you wouldn't otherwise have access to with a small amount of upfront capital. Leverage is best used in short-term, low-risk situations where high degrees of capital are needed.
While a traditional ETF typically tracks the securities in its underlying index on a one-to-one basis, a LETF may aim for a 2:1 or 3:1 ratio. Leverage is a double-edged sword since it can lead to significant gains, but can also lead to significant losses.
The two major risks associated with leveraged ETFs are decay and high volatility. High volatility translates to high risk. Decay emanates from holding the ETFs for long periods.
Leveraged decay refers to the process by which leveraged ETFs strictly adhere to a "daily rebalancing" rule to ensure that they consistently achieve an N-times tracking effect by the end of the day or before the next trading day opens, resulting in decay.
Because of how leveraged ETFs are constructed, they are only intended for very short holding periods, such as intraday.
"They all go to 0 over time." "If you hold them for more than a few days, you will lose money." The 3x Long Nasdaq 100 ETF (TQQQ) was launched in February 2010, over 8 years ago. Since its inception, it has advanced 4,357%, versus a gain of 378% for the unleveraged Nasdaq 100 ETF (QQQ).
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.
TQQQ seeks daily returns that are three times those of the QQQ (before fees and expenses.) QQQ experiences smaller price fluctuations and is considered to be less risky than TQQQ. Therefore, QQQ is best suited for long-term buy-and-hold investors, while TQQQ is better for active taders.
The constant rebalancing of leveraged ETFs creates higher costs, which eat into the investors' returns. Experienced investors who are comfortable managing their portfolios may be better off controlling their index exposure and leverage ratio directly, rather than through leveraged ETFs.
Are concerns about leveraged ETFs overblown?
By some estimates, returns generate up to 74% less rebalancing by leveraged and inverse ETFs once capital flows are taken into account. As a consequence, the potential for these types of products to exacerbate volatility should be much lower than many claim.
ProShares UltraPro QQQ is the most popular and liquid ETF in the leveraged space, with AUM of $21.9 billion and an average daily volume of 67.3 million shares a day. The fund seeks to deliver three times the return of the daily performance of the NASDAQ-100 Index, charging investors 0.88% in annual fees.
BMO has launched the first quadruple leveraged ETN fund that tracks the S&P 500. The fund will trade under the ticker symbol "XXXX" and seeks to generate four time the S&P 500's return on a daily basis. The launch come as bullishness rise among investors and Wall Street predicts more gains to come in 2024.
Most leveraged and inverse ETFs reset each day, which means they are designed to achieve their stated objective on a daily basis. With the effects of compounding, over longer timeframes the results can differ significantly from their objective.
Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.
Direxion launched its first leveraged ETFs in 2008. In November 2008 the company was the first to offer ETFs with 3X leverage, a move that was copied some months later by its competitors ProShares and Rydex Investments.
Because they rebalance daily, leveraged ETFs usually never lose all of their value. They can, however, fall toward zero over time. If a leveraged ETF approaches zero, its manager typically liquidates its assets and pays out all remaining holders in cash.
The Direxion Daily Junior Gold Miners Index Bull 3x Shares (JNUG) and the Direxion Daily Junior Gold Miners Index Bear 3x Shares (JDST) are the two most volatile exchange-traded funds of all. Each has a one-year volatility reading of about 170.
In other words, you could potentially be liable for more than you invested because you bought the position on leverage. But can a leveraged ETF go negative? No. If you own a leveraged ETF you can't lose more than your initial investment amount.
Historical data shows that leveraged ETFs can experience significant losses during market downturns, and negative returns can accumulate over time. Indicators suggest that a bubble may be forming in the Nasdaq-100 and that a recession could be on the horizon, making investing in TQQQ too risky.
What's the longest you should hold TQQQ?
While the Fund has a daily investment objective, you may hold Fund shares for longer than one day if you believe it is consistent with your goals and risk tolerance. For any holding period other than a day, your return may be higher or lower than the Daily Target. These differences may be significant.
For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.
The purpose of leveraged ETFs is to amplify the daily returns of an index instead of simply matching the index's performance.
Inverse or short ETFs are created using financial derivatives such as options or futures. They can even be created to move at two or three times the movement of the target asset. Because of how they're created, though, the value of these ETFs tends to decay over time.
Let's take a look at one of the oldest leveraged funds, Rydex's Nova Fund (RYNVX). The fund's first full year of operation was in 1994. For the 18-year period 1994-2011, the S&P 500 Index provided an annualized return of 7.7 percent.
