Leveraged Decay: The Dangers of Long-Term Investing with ETFs
Calder Lamb - Oct 06, 2015
Leveraged ETFs are exchange-traded funds that use debt and derivatives to amplify the daily gains of an underlying index. These vehicles are still subject to market pressures of buying and selling, and while they are designed to mimic the daily returns of the underlying asset, they don’t match the underlying asset exactly.
Volatility & Decay
Structured, leveraged ETFs provide an amplified return for a single day. Just one. Then they reset and provide that same amplified return for the next day. That’s the biggest misconception many investors have about leverage ETFs. They assume that if the index is up 8% for the year, then their 2x leveraged ETF will be up 16%.
That is not the case.
The problem with leveraged ETFs and why they get a bad rep has to do with a concept called decay. It’s this decay that cause them to receive such ire from many market pundits. And it’s an easy concept to illustrate.
If an index rises 5% and goes from 100 to 105, then a 2x leveraged ETF would jump to 110. That’s all well and good, and you’ve made some extra cash for doing essentially nothing. The issue is when the index then falls.
If the next day, the index drops back down from 105 to 100 — a 4.76% loss — the leverage ETF begins to show its decay problem. Twice the drop (9.52%) would send the 110 leveraged ETF down to around 99.5. You now need even bigger positive gains to break even on your leveraged ETF investment.
This decay issue is how some leveraged ETFs can actually finish with losses for the year, when their parent indexes finish with positive gains. For example, the Direxion Daily S&P 500 Bull 3X Shares (SPXL B+) managed to lose 16% during 2011, even though its benchmark — the S&P 500 — ended at around the same price point as in the beginning of the year. The decay throughout the year caused the leveraged ETF to dip negative and never regain a positive position.
And yet, sometimes over long periods, leveraged ETFs do work. The (SPXL B+) managed to return roughly 118% in 2013, while the S&P 500 only gained 32%.
The reason for the outperformance has to do with low volatility and trending higher markets. When the market is weathering a storm and jumps around more, you have more of the decay effect. Volatility kills leveraged ETFs. The swings in leveraged ETFs will be two to three times that of a parent index. The real issue is trying to guess how volatile the markets will be as well as the overall trending direction. Which is why many advisors and market pundits have suggested that leveraged ETFs are bad for the long term.
The Fees Will Drag Down Overall Investment Value
All ETFs charge management fees for providing the service of constructing and managing the ETF’s day-to-day operations. Leveraged products generally charge more than regular ETFs. A good rule of thumb is the more complicated the ETF, the larger the fee.
The longer an investor holds an ETF, the more fees he or she will have to pay. However, compared to mutual funds, ETFs (even leveraged ones), still offer great value when it comes to fees.
The Bottom Line
Leveraged ETFs are best used for investments with a clearly defined directional environment and with holding periods of less than one year. The chance for a massive drawdown, and the subsequent inability to get out of the drawdown, is simply too large of a risk for a long-term retail investor.
Leveraged ETFs should be used in trading situations where there is a strong conviction in market direction and with a clearly defined trading strategy. Simply buying and holding leveraged ETFs in an uncertain market environment will not benefit the long-term investor and will negatively impact their returns.
