Leveraged Exchange-Traded Funds: An Overview

Leveraged exchange-traded funds offer a multiple of the daily return of an index and are not meant to be held as long-term investments. The mathematics of compound interest means that volatility will reduce your long-term return. This is known as volatility drag. Leverage amplifies the volatility and also the return-sapping effects of the volatility drag. Thus, poor returns will result whenever you hold these ETFs longer than their indicated compounding period (typically one day for stock-based ETFs, sometimes monthly for commodities). The longer you hold one of these funds, the probability that it will underperform the multiple of a longer term return increases. Not only will the magnitude of your returns bounce around, you might not even get returns that are in the same direction as the changes in the index.

Some challenges to consider

Identifying an actionable investment thesis (i.e., stocks look cheap) is difficult. Trying to also predict the exact timeframe over which your idea will become reality and handling the risk when the market moves against you is even more difficult. Finally, actually detailing the path—knowing how volatile the daily price swings will be and in which direction—is nearly impossible. If you intend to hold leveraged ETFs beyond their compounding periods, you'd have to be right on all these factors to get double the index's return. In other words, when employing leverage and compounding returns, predicting how the underlying index will perform over the long term is only part of the challenge. You also have to correctly predict the path the investment is going to take.

To illustrate …

Let's say that an index goes up 10% one day and down 10% the next. Over the two day period, the index is would have lost 1%. Although the average return is zero, the compound return is less than that due to volatility. A 3x leveraged product would have lost 9%.

Leveraged ETFs are often issued in pairs with one ETF offering a positive multiple (bull or long) and one an "inverse" or negative multiple (bear or short) of the index. It is common for both the bull and bear versions of a leverage index to both have negative returns over long time periods.