Leveraged ETFs (Exchange-Traded Funds) are not like your usual ETFs. Similar to regular Index ETFs, they also replicate an underlying index consisting of different securities. However, they try to multiply the returns of the underlying index, and they do this by using financial derivatives and debts. Many finance experts advise traders against holding these instruments for the longer term, as the value of leveraged ETFs decays over time. But why do leveraged ETFs decay over time and why should you look elsewhere for longer-term investments?
Leveraged ETFs decay over time due to higher expense ratios, market volatility, and most importantly because of daily rebalancing. With leveraged ETFs, for an investment to remain stagnant, a sizably higher positive return percentage is needed to compensate for the negative return on a preceding day.
Contrary to what some investment or trading gurus will have you believe, leveraged ETFs are not advisable investments, as they expose you to very high risk. It is true that these instruments can give you impressive returns, but it is considered riskier to hold them over the longer term in comparison to regular ETFs. This article will look more into leveraged ETFs and the different reasons that cause them to decay over time.
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3 Reasons Leveraged ETFs Don’t Make Good Long Term Investment
The main reason why leveraged ETFs decay over time is because of daily rebalancing.
The principle of ETFs is that they reproduce the underlying index by two or three times, meaning if there is a 3% increase on the underlying index, you will enjoy a 9% increase.
Similarly, if there is a 3% drop in the underlying index, you will suffer a decline of 9% in your returns. So even if there is the same percentage rise the following day, it will still not make up for that original loss, as you would need a higher percentage rise to make up for that loss. If this continues over time, you can experience a huge loss on your initial investment.
With that preview out of the way, there are three main reasons why leveraged ETFs are not suitable for long-term investments. These are:
- Expense ratio
- Daily rebalancing
- Volatility
Now, let us briefly discuss each of these three reasons.
Expense Ratio
The expense ratio refers to the fees that your ETF charges for its services, such as:
- Portfolio management
- Administrative and maintenance costs
- Distribution or movement of assets
- Legal and accounting expenses.
The expense ratio is calculated by dividing the total fund costs by the total assets recorded in percentage.
When using a leveraged ETF, the expense ratio will be higher than other standard ETFs, which will cut deep into your returns. Consequently, if you go ahead to pick a leveraged ETF with a long-term investment plan, the high expense ratio that you will pay will keep cutting into your profit and increasing your losses in case the market moves against you.
This is one of the most common reasons why experts claim leveraged ETFs to end up in a loss over time. Therefore, if you’re going to invest in a leveraged ETF, it is advisable to treat these instruments as a short-term vehicle.
Daily Rebalancing
Daily rebalancing is another factor that causes significant loss in leveraged ETFs. This refers to the reallocation of securities to meet up with the initial or preset composition and involves buying and selling securities in a portfolio to ensure overall stability.
ETFs rebalance every day to minimize risk. However, while this might not have too significant of an impact on the traditional forms of ETFs, this can cause a substantial and irrecoverable blow on leveraged ETFs.
An attempt to balance out the portfolio of the underlying index can result in a fall that will be multiplied by the number of times the leveraged ETF has boosted the underlying index.
It’s the same as what has been said earlier. If the underlying ETF is increased by 2% and there is a drop of 5%, the leveraged ETF will reflect a loss of 10% instead.
So even in the event where the value of the underlying security increases the next day, there will still be a deficit, and making up that lost 10% will be difficult. If this trend continues, it is possible to start having returns on the negative side even though the value of the index might be beginning to rise.
One thing to note is that the rebalancing of stock takes place every day, and there will always be rises and falls. So, it is possible to lose a sizable percentage of your investments with these if proper care is not taken.
Because a loss will need to be followed by a much higher increase before it can cancel out, and that doesn’t always happen due to volatility – which is our next discussion point.
3. Volatility
Volatility refers to the statistical measure of the degree of change on the returns of security. In simpler terms, it is the measure of how often and by how much the prices of given security change from the original market value.
Under normal circumstances, high volatility can be a good thing because it opens up opportunities for making large profits quickly. However, increased volatility also exposes you to a significant measure of risk, which can equally result in losses.
For proponents of index fund investing using regular ETFs, high volatility is more good than bad because over the long term its negative impact will more or less be minimal. However, the case is quite different for leveraged ETFs.
If the underlying index of a leveraged ETF shows high volatility, it is a considerable risk.
Because if there is a loss at that point in the market, the loss will be significantly multiplied. The same goes for if there is a profit. The profit will also be multifold with respect to the movement in the index. However, the damages incurred from a loss far outweigh the benefits from a rise in value. This is because, to keep your investment value at the same level, you will need a much higher percentage rise to make up for the loss made on the previous day.
Moreover, with high volatility, there is the possibility of making continuous losses, and by now, we can understand what that means for a leveraged ETF.
Leveraged ETFs are not all bad, if you know what you’re doing, however.
You can enjoy massive returns from this form of ETF. But, these instruments are more suitable for short-term investing. Holding these instruments over a longer horizon can leave you with far less than what you initially invested.
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Conclusion
Leveraged ETFs decay over time and are not suitable for long-term investment because of daily balancing, volatility, and their higher expense ratio.
If you want to make sure that your portfolio survives even the worst economical declines, you’ll want to diversify using other investment vehicles such as regular ETFs, mutual funds, or holding a variety of individual stocks, bonds, and other financial instruments.
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