The Big Myth about Leveraged ETFs: Dispelling Misconceptions and Unveiling Opportunities in Long-Term Investing

Alessio Frateily

Hatched by Alessio Frateily

May 28, 2024

4 min read


The Big Myth about Leveraged ETFs: Dispelling Misconceptions and Unveiling Opportunities in Long-Term Investing

Leveraged ETFs have long been the subject of controversy and skepticism in the investment world. Many critics argue that these funds are unsuitable for long-term buy and hold strategies, citing concerns about deteriorating returns, compounding losses, and excessive volatility. However, it's essential to dive deeper into the topic and explore the nuances before dismissing leveraged ETFs entirely. In this article, we will debunk the myth surrounding leveraged ETFs and shed light on their potential benefits for long-term investors.

One of the primary arguments against leveraged ETFs is the concept of volatility drag. Critics claim that daily market fluctuations can erode the returns of leveraged ETFs, even when the underlying benchmark exhibits minimal volatility. This notion stems from the equation (1 - x)(1 + x) = 1 - x^2, where x represents the daily market movement. Let's consider an example: if the market goes up by 5% one day and then down by 5% the next day, the net result is a decrease of 0.25% in the leveraged ETF's value. This discrepancy between the market's movement and the ETF's performance seems unfair and has contributed to the myth surrounding leveraged ETFs.

To understand leveraged ETFs better, we must define them accurately. For our purposes, a leveraged ETF is any fund that promises returns of a multiple of its benchmark's daily return, as specified in the prospectus. This multiple can be any number, including negative values or decimals. Surprisingly, even an ETF with a leverage of 1 (which technically isn't considered leveraged by most people) experiences volatility drag. The negative sign in front of x^2 ensures that volatility drag is a universal phenomenon in leveraged ETFs.

The myth surrounding leveraged ETFs arises from the belief that volatility drag will eventually drive these funds to zero over time. However, this assumption is not entirely accurate. While leverage 1 (no leverage) is generally considered safe to hold indefinitely, the safety of leverage 1.01 or 1.1 is debatable. Drawing a definitive line between safe and unsafe leverage ratios becomes subjective. Perhaps leverage 2 is safe, but why shouldn't leverage 2 ETFs be suitable for long-term holding? The answer lies not in volatility drag but in other factors.

To explore these factors, we need to delve into the formula for the long-term compound annual growth rate (CAGR) of a leveraged ETF. Unlike conventional formulas based on Gaussian assumptions and continuous returns, the CAGR formula for leveraged ETFs involves terms related to the benchmark's skewness and kurtosis. While this may sound complex, it reveals an interesting pattern. When plotting various markets and leverage ratios on a contour chart, we observe that the optimal leverage for most markets (excluding the Nikkei 225) over the past few decades is approximately 2. This finding suggests that leveraged ETFs can be held long term if the market generates enough return to overcome volatility drag.

However, there is one critical factor that investors must consider before embracing leveraged ETFs for the long term: fees. Most leveraged ETFs with leverage greater than 1 charge an annual fee of around 1%. This fee imposes a "fee drag" on the ETF's performance, reducing the overall returns. Additionally, leveraged ETFs are prone to tracking error, meaning they may not precisely match their target returns on a daily basis.

Taking all these factors into account, here are three actionable pieces of advice for investors interested in leveraged ETFs:

  • 1. Understand the specific leverage and fee structure of the ETF: Before investing, thoroughly review the prospectus and understand the ETF's leverage ratio and associated fees. Higher leverage ratios and excessive fees can significantly impact long-term returns.
  • 2. Consider the market conditions and historical performance: Analyze the historical performance of the leveraged ETF in relation to the underlying benchmark. Look for patterns that indicate the potential for generating consistent returns despite volatility drag. Consider the optimal leverage ratio for the specific market you're interested in.
  • 3. Diversify your portfolio: As with any investment, diversification is crucial. Don't rely solely on leveraged ETFs, but rather incorporate them into a well-diversified portfolio that includes traditional investments. This approach can help mitigate risks and offset potential losses.

In conclusion, the myth surrounding leveraged ETFs being unsuitable for long-term buy and hold strategies is not entirely accurate. While volatility drag poses a challenge, leveraged ETFs can still be viable options for investors seeking enhanced returns. Understanding the nuances, considering market conditions, and carefully evaluating the fee structure are essential steps for successful long-term investing with leveraged ETFs. Remember, knowledge and informed decision-making are key to unlocking the potential of leveraged ETFs within a diversified portfolio.

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