The Hidden Risks of Leveraged ETFs: What You Need to Know

Leveraged ETFs can feel like a financial thrill ride—they promise the potential for amplified returns, which sounds like a dream come true for any investor. But, as with most things that sound too good to be true, these exciting prospects come with some serious risks. If you're not careful, leveraged ETFs can turn that thrill into a rollercoaster of losses. Let’s break down what makes these investment vehicles attractive and why it's crucial to fully understand their risks before jumping in.

What is an ETF?

An ETF, or Exchange-Traded Fund, is a type of investment that holds a collection of assets like stocks, bonds, or commodities and trades on an exchange like a stock. ETFs are often designed to track the performance of a particular index, such as the S&P 500, allowing investors to buy into a broad range of assets with a single investment.

Now, add leverage to the mix, and you get Leveraged ETFs—which aim to amplify the returns of an index by a factor of two or three. These instruments use financial derivatives like futures contracts and swaps to achieve this goal. While this can magnify gains, it can also magnify losses, sometimes by two or even three times the movement of the underlying index.

How Do Leveraged ETFs Work?

A leveraged ETF aims to multiply the daily returns of an underlying index. For example, a 2x leveraged ETF is designed to deliver twice the performance of the index on any given day. So, if the index rises by 1%, the leveraged ETF should theoretically increase by 2%.

But it’s not all magic. These ETFs rely on derivatives to generate this amplified exposure. While it can supercharge your gains, it also works in reverse—if the index drops by 1%, the leveraged ETF could fall by 2% or more.

The Hidden Danger of Compounding Risk

Here’s where things get tricky—leveraged ETFs are primarily suited for short-term trading, and the reason for this is compounding risk. Unlike regular ETFs, which simply mirror an index, leveraged ETFs reset their exposure daily. This daily resetting creates a compounding effect, which can lead to decay over time, particularly in volatile markets.

Example:

On Day 1, the underlying index rises by 10%, so your 2x leveraged ETF goes up by 20%. Sounds good so far! But on Day 2, the index drops by 10%. You’d think your ETF would drop by 20%, leaving you still ahead after both days. Unfortunately, that's not the case because of compounding.

After Day 1, your ETF is worth 120% of its original value. However, when the index drops by 10% on Day 2, that 10% loss is applied to your ETF’s new value, not the original. Instead of a 20% drop, your ETF falls by 24% of its current value. Now, your ETF is only worth 91.2% of what you originally invested - even though the index itself is back where it started.

This is the compounding decay effect, where daily resetting and market volatility erode your returns over time. The more volatile the market, the more pronounced this effect becomes. Small, repeated losses stack up, leading to a significant erosion in value, especially for those who hold leveraged ETFs for extended periods.

Why This Matters Over Time

While this example shows the effects over two days, imagine it happening over weeks or months. If the market experiences continuous ups and downs, these small losses can snowball, and your leveraged ETF may significantly underperform the index it's meant to track. This is why holding leveraged ETFs for the long term can be risky - they may not accurately reflect the performance of the underlying index over time.

Strategies for Trading Leveraged ETFs

Leveraged ETFs aren’t necessarily bad; they just require a disciplined approach. Here are a few strategies that traders use to navigate these tools effectively:

1. Short-Term Trading: Leveraged ETFs are meant for short-term trades. Whether you’re aiming to capitalise on an expected market jump or preparing for a downturn, these ETFs should only be used as part of a day trading or swing trading strategy—not as long-term investments.
2. Hedging: These ETFs can also be used for hedging. For instance, if you’re heavily invested in a sector and anticipate short-term volatility, a leveraged inverse ETF can help protect against market declines.
3. Limit Your Exposure: Due to the risks, it’s a good idea to limit how much of your portfolio is allocated to leveraged ETFs. These products can be volatile even if you’re confident in your market predictions. Only invest what you’re comfortable losing.

Conclusion: Know the Risks, Enjoy the Rewards

While the idea of doubling or even tripling your returns sounds tempting, the risks associated with leveraged ETFs are no joke. They can be powerful tools for experienced traders who know how to handle them, but they’re not for the faint-hearted or inexperienced. If you understand the risks—like compounding decay and volatility—and approach them cautiously, leveraged ETFs can offer short-term opportunities. But always keep in mind that with greater rewards come greater risks.?

Disclaimer: The views and opinions expressed in this article are those of the author. They do not necessarily reflect the official policy or position of any agency, organisation, employer, or company. The information provided is for general informational purposes only and should not be considered professional or expert advice.

Sources:

1. Investopedia. "Leveraged ETFs: Good, Bad or Ugly?"?
2. Morningstar. "Understanding Leveraged ETFs and Their Risks." U.S. Securities and Exchange Commission (SEC). "Investor Bulletin: Leveraged and Inverse ETFs."