Exchange-traded funds (EFTs) are a popular option among most investors, especially those with a long-term vision and low-risk tolerance. But is it true that they gradually lose their value?
ETFs can lose value over time if they use leverage. One reason is due to the way leveraged ETFs work. Another is the higher management fees they have compared to non-leveraged ETFs.
To understand why leveraged ETFs lose value over time, we need to understand what leverage is. But first, we need to understand ETFs in general and how leveraged ETFs are different. In the rest of this article, I explain leveraged and non-leveraged ETFs and their key differences alongside describing the reasons why leveraged ETFs lose value over time.
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Table of Contents
Is an EFT Different From a Mutual Fund?
An exchange-traded fund (ETF) is very similar to a mutual fund. Both ETFs and mutual funds are financial investment mechanisms with a portfolio of securities. The portfolio could include stocks, bonds, options, currencies, commodities, or a blend of different securities.
The difference involves when trading can happen. Mutual funds are only traded once per day after the markets close. ETFs, however, are traded on the exchange like stocks. They may be bought or sold at any time throughout the day while the markets are open.
All ETFs match their underlying index. If the index is up, the ETF is up by the same or similar percentage. Likewise with losses. Overall, the difference in return is very similar to the change of the index it is following.
What Is a Leveraged ETF?
A leveraged ETF is like an ETF, but it uses debt and other financial products to boost the return of its underlying index. It multiplies the return by a factor of two or even three. The most common design is to have an investment objective of one day.
A leveraged ETF’s purpose is to provide an investor with a greater return on investment than a non-leveraged ETF that only matches its underlying index one-to-one.
The return on investment (ROI) can be very good or very bad. When the index is up, the ETF’s gain increases two or three times that of the non-leveraged ETF. When the index is down, the suffered loss is of the same magnitude.
How Do Leveraged EFTs Lose Value?
It’s possible, if not likely, that a leveraged ETF will lose value over time. The decline in value is mainly due to daily rebalancing, making it challenging for these instruments to recover from losses.
Rebalancing is required for a leveraged ETF to maintain its investment objectives. Rebalancing a leveraged ETF involves buying or selling positions in its portfolio to keep the desired allocation level.
For example, suppose the index has a loss of 5%, then a 2-times leveraged ETF would realize a 10% loss. If that ETF has a value of $100, the loss reduces it to $90.
The next day the index goes up by 5%; the index has a net-zero two-day change. Because of rebalancing, the leveraged ETF’s gain calculation uses the $90 value.
The fund has a new value of $99, not $100. Since the index value fully recovered on day 2, one might think the leveraged ETF would regain 100% of its value.
To better understand how a leveraged ETF can lose value, let’s compare a non-leveraged ETF and a three-times (3x) leveraged ETF over four days of trading. In this scenario, the purchase price of these products was $1000.
| Day | Index Change | Index Return Since Day 0 | ETF Loss/ Gain | ETF Value at Close | 3x ETF Return Since Day 0 | 3x ETA Loss / Gain | 3x ETF Value at Close |
|---|---|---|---|---|---|---|---|
| 0 | n/a | n/a | n/a | $ 1000.00 | n/a | n/a | $ 1000.00 |
| 1 | -10% | -10.0% | -$ 100.00 | $ 900.00 | -30.0% | -$ 300.00 | $ 700.00 |
| 2 | +15% | 3.5% | $ 135.00 | $ 1035.00 | 1.5% | $ 315.00 | $ 1015.00 |
| 3 | -8% | -4.8% | -$ 82.80 | $ 952.20 | -22.9% | -$ 243.60 | $ 771.40 |
| 4 | +8% | 2.8% | $ 76.18 | $ 1028.38 | -4.3% | $ 185.14 | $ 956.54 |
At the end of trading on day 1, as expected, the loss for the leveraged ETF was more than the non-leveraged ETF. On day 2, the index more than recovered from its losses on day 1. The leveraged ETF’s value is still lower than the non-leveraged ETF.
By day 4, the leveraged ETF shows a loss, but the non-leveraged ETF has a profit. Because the leveraged ETF suffered a substantial loss on day 1, it may not recover quickly, if at all.
The math shows how the multiplier exaggerates both the gains and losses of the leveraged ETF. The longer an investor holds the leveraged ETF, the more likely the fund will lose value.
Keep in mind that the above hypothetical scenario doesn’t take fees or interest costs into account. These costs are higher with a leveraged ETF than the traditional type.
Higher costs mean a higher expense ratio and more significant degradation of the returns.
Some of the more popular leveraged ETFs have an expense ratio of around 1.0%. The average expense ratio of a traditional ETF is closer to 0.5%. To cover expenses, the fund must reduce the amount of its return. The greater the expense ratio, the more the fund value is diminished.
Why Leveraged ETFs Have a Higher Expense Ratio?
Leveraged ETFs have higher expense ratios because, to provide higher returns, they use derivative investments, which have hefty fees. Furthermore, leveraged ETFs can use debt which results in interest charges. Finally, these instruments also incur higher trading fees and commission rates due to daily rebalancing.
What Are Derivatives?
Derivatives are financial instruments that derive their value from their underlying asset. They’re typically options, futures, or swaps. However, the types of derivatives continue to increase in number and variety.
Futures and options are similar in that they’re contracts between two or more parties agreeing to buy or sell a security at a specific price at an agreed-upon future date. The essential difference is that an option is an opportunity to trade and not an obligation. A future is an obligation.
Swaps are a common derivative. A swap’s most common use is exchanging different types of cash flow. A simple example is when the contract uses an interest rate swap to switch a fixed-rate loan to a variable-rate loan.
What Is Buying on Margin?
When an investor decides to borrow money from a broker to purchase a financial asset, it’s known as buying on margin.
The investor uses the cash from the loan as collateral against the purchase. The margin is the difference between an investment’s value and the amount of the loan.
Can a Leveraged ETF Be a Good Investment?
There’s a possibility that a leveraged ETF could be a good investment and provide a more significant return. But the more likely result is a considerable loss. Experienced investors should be the only ones dabbling with this risky type of investment. For most investors, they’re not a good choice.
An experienced investor who has done the research might have a greater chance of making a profit.
For example, suppose an investor is watching the price of crude oil and believes the price will go up. Investing in a crude oil leveraged ETF might be a good idea, as long as they sell it before the price decreases.
Day traders are a type of experienced traders who typically invest in leveraged ETFs. They buy and sell on the same trading day and usually do not keep them as long-term investments.
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Conclusion
The high risks, high costs, and the expected market volatility make leveraged ETFs a less-than-ideal option for investors interested in a long-term investment. The probability the average investor will lose the entire value over the long term.
Leave these types of investments to experienced traders who know how to research and mitigate the potential of a significant loss.
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