Daily leveraged funds are still quite new to the retail investor. The first 2x leveraged ETFs tracking broad market indices started trading in the middle of the last decade.
Just a few years later, anyone investing in these ETFs who was not sure about their performance in all market conditions was rudely woken. The largest 2x fund tracking the S&P 500 suffered from an 85% drawdown in the 2008-09 Financial Crisis. That's correct, every $1,000 in this ETF shrank to a mere $150.
Since that time, the you've heard the warnings over and over. From the financial news, your run-of-the-mill financial advisor, most financial blogs and online sources, and even the large and prominent disclaimers on fund provider websites.
Like this one directly from Horizons Canada's website:
"The ETF uses leverage and is riskier than funds that do not. The ETF seeks a return, before fees and expenses, of +200% or - 200% of its Referenced Index for a SINGLE DAY. The returns of the ETF over periods longer than ONE DAY will likely differ in amount, and possibly direction (of the performance, or inverse performance, as applicable) of the Referenced Index. Longer periods AND/OR greater volatility will make the possible divergence more pronounced. Investors should monitor their investment in this ETF daily. Please read the prospectus and ensure you understand this ETF before investing in it."
The prevailing wisdom is simplified to this: leveraged ETFs are very, very risky. They are only for use by a professional day trader who watches their brokerage account throughout every trading day. Do not hold leveraged ETFs unless you want to lose your money.
What Does the Data Say
For a few years now I've been quite skeptical of these claims. It is only logical that daily leveraged funds of reasonably stable indices should outperform their underlying index over longer periods of time, even after adjusting for fees.
I believe the argument made by the crowds is an oversimplified one. Certainly a leveraged daily fund will not provide an exact specified multiple return over the underlying index for any period greater than one day. Volatility guarantees that. Large down days do damage, while positive returns over numerous days compounding each day provide outsized returns.
However, it's time to debunk the myth of danger surrounding these funds. Over the past weeks I've compiled a large spreadsheet of daily returns for the S&P 500 since the beginning of 1950. Then I simulated the annual performance of daily leveraged funds from 1950 to 2017.
In the 68 calendar years of data I compiled, a 3x daily leveraged fund would have returned a 2.5x or higher multiple of the S&P 500 in 53 of those years. Further, an another 11 years would have still been a positive multiple of the index, although less than 2.5x.
This means in 95% of all years in more than one-half of a century, a 3x daily leveraged fund would have returned a positive multiple of the S&P 500.
In just four years the annual return was negatively correlated to the underlying index: 1960, 1987, 2011, and 2015. The pattern in each of these four cases is quite similar. In 1987, 2011, and 2015 the stock market had a correction which occurred near the end of the calendar year. In 1960, the market was just very up and down from start to finish. In 1960, 2011, and 2015 the S&P 500 was just barely positive on the calendar year, so the negative multiple return of the leveraged fund would not have had a substantial impact on the investor.
The only year where the 3x leveraged fund would have a large negative impact was 1987. As most investors with some knowledge of market history know, 1987 was a memorable year. In a single day, October 19, the U.S. stock market experienced its largest daily fall ever with a -20.47% return. On a 3x daily leveraged fund, that translates to a single day return of -61.41%. As you would expect, a large daily loss of this magnitude takes time to recover.
However, if it's any consolation, in four years since 1950 a 3x leveraged fund would have returned more than 4x the underlying S&P 500 index thanks to the power of daily compounding of positive returns: 1953, 1954, 1958, and 1990.
The data shows that a daily leveraged fund performs according to its expected return over the course of an entire calendar year more than 80% of the time. This is a high rate of success and shows that in the vast majority of market conditions daily leveraged funds on broad market indices are not significantly impacted by the historic market volatility.
In the past 67 years, there was only a single year where holding daily leveraged funds of the S&P 500 would have negatively impacted a investor to a substantial degree because of volatility induced tracking error. I believe it's safe to say 1987 was a unique year in stock market history that is not likely to be frequently repeated in the future.
While all investing with leverage carries risks that are amplified when not used properly, the common wisdom that leveraged ETFs should be used for short-term or day trading only is misplaced. Under the vast majority of market conditions throughout history, the divergence of daily leverage when held for longer periods of time is not substantial.
Always remember when the underlying index enters an extended drawdown, the effects of that drawdown will be amplified with daily leveraged ETFs. This is common and should be expected. Despite their simulated tracking history over long time periods being better than commonly held beliefs suggest, it would be reckless to allocate the majority of your portfolio or tax-advantaged account within your broader portfolio to a leveraged ETF.
Comments & Questions
All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.
Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.