Not Investment Advice: The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.
Summary
- Leveraged ETFs amplify returns of underlying indices through derivatives, with common ratios of 2x/-2x and 3x/-3x.
- Advantages of leveraged ETFs include magnified returns in bull markets, portfolio diversification, and hedging possibilities.
- Timing and risk management are crucial due to the impact of volatility and higher fees in leveraged ETFs.
- Approaches to using leveraged ETFs include ignoring them, using static positions for diversification, and tactical exposure strategies.
Introduction
Leveraged ETFs (Exchange Traded Funds) have been a hot topic in the world of investing, and they continue to entice both seasoned investors and newcomers. These financial instruments offer the potential for enhanced returns, but their risks can be as alluring as their rewards. In this article, we’ll explore the use of leveraged ETFs for investors and shed light on their advantages, potential pitfalls, and how an investor might use leveraged ETFs in their portfolio.
Understanding Leveraged ETFs
Leveraged ETFs are investment vehicles designed to amplify the returns of a given index or asset by employing financial derivatives, such as futures and options contracts. The most common leverage ratios include 2x and 3x, which aim to double or triple the daily returns of the underlying index. For example, SSO tracks the S&P 500 and if the S&P 500 rises by 1% in a day, SSO would ideally increase by 2%. Likewise, if the S&P 500 falls 1% in a day, SSO should fall about 2%.
Volatility Drag
Volatility drag, or variance drain, impacts all financial assets as higher volatility results in a larger gap between geometric and arithmetic returns; however, as leveraged ETFs are reset daily, the impact of volatility drag is amplified. As an example, imagine two portfolios each starting with $1,000. One portfolio invests in SPY, and the other invests in SSO. The higher the leverage factor the higher the negative impacts of volatility drag.
| SPY % Change | SSO % Change | SPY Portfolio Value | SSO Portfolio Value |
| -5% | -10% | $950 | $900 |
| +5% | +10 % | $997.5 | $990 |
At the end of two trading days, the SPY portfolio is down just 0.25% (-$2.50), and the SSO portfolio is down 1% (-$10).
The Appeal of Leverage
1. Magnified Returns: The primary allure of leveraged ETFs is the potential for magnified returns. In bull markets, they can significantly outperform their non-leveraged counterparts as the streak of positive returns compounds on itself.
2. Portfolio Diversification: Leveraged ETFs can help diversify a portfolio by offering exposure to various asset classes, sectors, and geographies, with less cash and thus allowing excess cash to be invested into different assets.
3. Hedging Possibilities: Inverse leveraged ETFs (e.g., -2x or -3x) allow investors to profit from declining markets. These can serve as effective hedging tools for a bearish outlook or as a means of managing downside risk.
Compounding Returns
As we have seen, though leveraged ETFs are designed to track their benchmark by 2x or 3x, the impact of volatility can result in drastically different results when volatility is high. However, when volatility is low, and the underlying benchmark experiences a period of sustained upward movement, the returns can be magnified more than expected. In the period 01/2016 to 12/2018, SPY gained roughly 34%. Given SSO’s 2x mandate, we would expect returns of roughly 68% over the same period, but instead, SSO increased by nearly 82%!
The Importance of Timing and Risk Management
While the allure of leveraged ETFs is undeniable, prudent investors must approach them with caution:
1. Volatility Matters: As mentioned earlier, volatility is the enemy of leverage. Increased impact of volatility drag means that holding leveraged ETFs during sideways or choppy markets will result in lower-than-expected returns. This means, that even if the benchmark is flat over a given period, the leveraged counterpart can be down substantially.
2. High Fees: Compared to standard ETFs, the fees on leverage ETFs can be substantially higher. As an example, SPY has an annual fee of just 0.09%, while SSO (2x S&P 500) has an annual fee of 0.89%.
Controlled Chaos
Knowing the risks and benefits of leveraged ETFs sets the groundwork for determining how to use them.
- Ignore them all together: Deciding not to use them is a legitimate choice for investors who understand themselves and their goals. If you know seeing a position down 50% will make your stomach turn, then it’s smart to not put yourself in that position.
- Static Position to Increase Diversification: If you currently have a portfolio composed of 100% of stocks that means you can potentially use leveraged ETFs to increase portfolio diversification while keeping stock exposure constant. As an example, if you have 100% invested in SPY today that means your portfolio returns are 100% driven by the stock market. You can instead invest 50% in SSO, 50% in IEF (iShares 7-10 Year Treasury Bond ETF), and rebalance annually. This keeps your exposure to stocks the same on a dollar basis, but you can now invest in bonds to help diversify your portfolio return stream. From Jul 2006 – Sep 2023, such a portfolio would have achieved a CAGR of 9.9% vs SPY return of 9.3% and a maximum drawdown of 42% vs 51% in SPY.
- Tactical Exposure: We have seen that leveraged ETFs thrive during periods of strong positive returns and low volatility, and lag when the market turns down or experiences elevated levels of volatility. There is no perfect method to determine this, but a decent starting point is the 200 daily moving average. When SPY is above its 200 DMA, invest in SSO. When SPY crosses below its 200 DMA, move to cash. From Jan 2008 – Sep 2023, this simple method would have resulted in a CAGR of 14% compared to 9% of SPY, and a maximum drawdown of 33% compared to 48% in the SPY.
Conclusion
Leveraged ETFs can be a valuable tool for investors seeking enhanced returns and diversification, but they should be approached with a clear understanding of the associated risks. Proper timing, risk management, and a grasp of the impact of volatility are essential for success with these instruments. As with any investment, it’s important to conduct thorough research, understand your own risk tolerance, and consider consulting a financial advisor before integrating leveraged ETFs into your portfolio. When used wisely, they can be a potent addition to an investor’s toolkit.
Sources/More Reading
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Financial Disclaimer:
The information provided here is for general informational purposes only and should not be considered financial advice. The financial markets are subject to significant risks and fluctuations, and investment decisions should be made after careful consideration of your individual financial situation and objectives. It is essential to consult with a qualified financial advisor or professional before making any investment or financial decisions. No guarantees or warranties are provided regarding the accuracy, completeness, or suitability of the information presented. We are not responsible for any financial losses or damages that may result from the use of this information. Please conduct your due diligence and make informed choices when dealing with financial matters.