Think back to the height of the internet boom in 1999…
Twenty years ago, say you wanted to invest in gold or the British pound sterling or Russian stocks. You’d have to set up an account with a specialist broker.
Today, you can invest in any of these exotic asset classes by buying an exchange-traded fund (ETF) in any brokerage account at the click of a mouse.
The range of investment opportunities offered by ETFs today is nothing short of remarkable.
Yet there is a specialized class of ETF that has generated a great deal of controversy… and even calls for government regulation.
It’s made up of so-called “leveraged ETFs.”
Like regular ETFs, leveraged ETFs track an underlying index. But they use financial derivatives to offer investors two or three times the daily returns of their unleveraged counterparts.
The quick, short-term gains offered by leveraged ETFs are seductive. A well-timed leveraged ETF bet can generate 10%, 20% or even 30% gains within weeks.
But leverage is a double-edged sword.
On the one hand, leveraged ETFs can generate eye-popping returns over a short period…
On the other, a leveraged ETF that goes against you can ravage your portfolio during a market correction.
The Confusing Math Behind Leveraged ETFs
With leveraged ETFs, you’d think that you could just multiply the underlying index return by two or three times to calculate your rate of return.
But that’s not how the math works…
Leveraged ETFs are designed to deliver their advertised returns within a given day.
So if the Nasdaq 100 goes up by 1% today, the ProShares UltraPro QQQ (Nasdaq: TQQQ) – a triple-leveraged play on the Nasdaq 100 – should rise by 3%.
This also means that the valuation of leveraged ETFs must be reset daily.
So when you hold a leveraged ETF for longer than a day, your return depends on two things…
First and foremost, it depends on the price of the underlying asset on which the leveraged ETF is based. But, over time, it also depends on the volatility of the underlying asset.
Consider this example…
Say a leveraged ETF trading at $100 drops 10% to $90. The next day, it recovers 10%. This doesn’t mean that its price returns to $100. Instead, it rises to only $99 ($90 plus 10%, or $9).
The longer you hold the ETF, the more these distortions compound.
In practical terms, this means that leveraged ETF investors do well when volatility is low… And they fare poorly when prices fluctuate wildly.
Consider the Direxion Daily S&P 500 Bull and Bear 3X Shares (NYSE: SPXL).
Had you bought this at the start of 2019, you’d be sitting on an astounding 47% gain. That is well above the S&P 500’s 14% gain over the same period.
Now extend this comparison to six months to include the last three months of a very volatile 2018.
You’ll find that the leveraged ETF actually underperforms the S&P 500 over that period.
How to Play Nice With Leveraged ETFs
This unexpected behavior of leveraged ETFs has caught the attention of both regulators and ETF providers.
As far back as 2009, the Securities and Exchange Commission issued a warning that leveraged ETFs posed “extra risks” for buy-and-hold investors.
In January, The Vanguard Group banned the purchase of leveraged products for all of its clients.
The lesson is clear.
You should understand that leveraged ETFs are speculative, short-term investments.
A handful of triple-leveraged ETFs that I have recommended in Oxford Wealth Accelerator have already generated quick double-digit gains in 2019.
But these supercharged ETFs are not buy-and-hold investments.
If you don’t know what you’re doing, investing in leveraged ETFs is like playing with fire…
Make sure you don’t get burned.