Leveraged ETFs are viewed by some people as a way to magnify your gains quickly. They can do that if you play your cards right. They can also do the opposite (and quickly).
These products have grown in leaps and bounds over the past couple of years. ETFs and mutual funds providing 2x and 3x leverage by issuers, such as ProShares and Direxion, have been around for decades. More recently, funds offering leverage on single stocks have exploded both in number and assets under management (AUM).
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That’s what three straight years of double-digit gains for the S&P 500 (SNPINDEX: ^GSPC) will do. If investors are already in a bullish mood, perhaps they’ll be tempted by the opportunity to enhance their returns even further.
But leveraged ETFs are aggressive in a best-case scenario and downright dangerous in the worst. Use them as intended, and you have an opportunity to enhance your returns. Use them improperly or fail to understand them first, and you could wipe out a good chunk of your capital.
When investing in a leveraged ETF, in many cases you’re not investing in the underlying security. Instead, you’re investing in derivatives (most likely swap or futures contracts) designed to deliver a multiple of the security’s return on a daily basis.
Since their goal is to replicate a single day’s performance, the swap agreements and fund exposures need to be reset on a daily basis. That kind of frequent activity becomes costly, and it’s not unusual for leveraged ETFs to come with expense ratios of 1% or higher.
It’s this daily rebalancing and its impact on compounding that can create the most damage for shareholders. It can create what’s known as volatility decay, which is the idea that gains and losses compound asymmetrically. The wider the swings in a security’s price, the more that volatility decay can negatively impact returns.
This creates scenarios where you can lose money in a leveraged ETF even if you get the direction of the trade correct.
The best example of this occurred during the financial crisis. The Direxion Daily Financial Bull 3x Shares ETF (NYSEMKT: FAS) and the Direxion Daily Financial Bear 3x Shares ETF (NYSEMKT: FAZ) initially produced the returns that you might expect. As time wore on, however, the volatility of the stock market and this sector in particular took its toll. Within just a few months, both funds were sitting on massive losses.
