The Risk of Avoiding Leveraged ETFs

Plenty of people will never understand the best use cases for daily leveraged ETFs. That’s perfectly fine. Every investment is personal choice as well as a financial one. But the decision to avoid using daily leveraged ETFs shouldn’t be made based on poor information or cover-your-ass legalese.

Leverage can be a dirty word for many people. Some of the greatest investors condemn it (while using ample leverage themselves), people get stung by leverage, and anyone considering daily leveraged ETFs has inevitably come across legal warnings about daily leverage in volatile markets on the ETF provider websites. This includes recommendations to only use daily leveraged ETFs for short-term trading.

But the truth is nearly every person in a developed market is exposed to leverage. The concept is simple. If you borrow money to buy something, you are using leverage. Bank loans, mortgages, lines of credit, margin loans, and business leasing are all forms of leverage.

Leverage is a powerful tool. But it can be powerfully good or powerfully destructive. Just like people lost their houses in 2008-2010 due to poor use of leverage, you can wipe out your portfolio with poor use of leverage. On the flip side, responsible leverage can help build enormous wealth. There is not a single great investor I can think of who didn’t use leverage.

Some basic knowledge of leverage is only the first step in understanding daily leveraged ETFs. But a basic understanding of any complex subject is often more dangerous than not understanding the subject at all. For example, a basic understanding of electrical safety or food preparation is good—don't mix electricity and water, don't store food between 4C and 60C; however, a basic understanding of religious doctrine or stock trading is not. That is how we get destructive religious cults and people who blow up their trading accounts.

Many investors have a basic understanding of leverage and don’t see any issues with businesses borrowing to expand operations or people borrowing to own a larger home than they could otherwise purchase. That seems normal. But taking on leverage for trading or investing introduces a mental degree of separation. It adds another level of sophistication and complexity in an often already volatile world.

In truth daily leveraged ETFs are more sophisticated than most publicly listed stocks or common ETFs. Daily leveraged ETFs often involve derivative instruments called swap contracts and they may hold futures contracts. Swaps are similar to retail traded CFDs, but they are typically more customized for the needs of the parties involved. This means there is counterparty risk involved. A good ETF will have multiple swaps with different counterparties to reduce this type of risk

A daily leveraged ETF is also more risky than a standard ETF because it involves the use of leverage. If the underlying market moves 0.5 percent in a day, a 2x daily leveraged ETF will move approximately 1.0 percent, and a 3x daily leveraged ETF will move approximately 1.5 percent. We know that percentage movements to the downside hurt more than equal percentage moves to the upside.

The general pattern of returns that we see in equity markets introduces a trade-off when using daily leveraged instruments. Of the movements in equity markets, the largest daily moves tend to be on the downside; this causes an outsized amount of damage to the value of daily leveraged ETFs. Further, choppy markets of roughly equal size moves to the upside and downside hurt daily leveraged funds.

However, it's not all bad. Low volatility trending periods benefit leveraged ETFs more than their leverage implies because of daily rebalancing. Also, by their design, daily leveraged ETFs cannot go down to $0 in value. They may go down to $0.00001 (without unit consolidation), but never $0.

This added sophistication and risk in the instrument itself is all the more reason to use them carefully. When placed in a properly constructed portfolio for capital efficiency and risk reduction (yes… I mean less risk), daily leveraged ETFs are awesome.

The more one looks into them, the stronger their use case becomes for long-term holdings as part of a regularly rebalanced portfolio. These ETFs are not just for day trading. In fact, that's probably a very poor use case for leveraged ETFs—except maybe commodity ETFs that suffer significantly from rolling costs.

By simulating historical returns for daily leveraged funds, including fees and dividends, we can easily compare a standard 60/40 portfolio (S&P 500/short-term bonds) to a similarly performing portfolio that uses leveraged ETFs. The results are surprising.

On first glance an individual with almost no knowledge might assume that the investor would need at least 20 percent of their portfolio in a 3x leveraged ETF to equal a portfolio with 60 percent in the S&P 500. An individual with a basic understanding of the characteristics of these funds would assume even more exposure would be necessary to make up for the higher fees and oft-discussed volatility penalties of these funds. They would both be wrong.

When simulating a 3x daily leveraged S&P 500 fund back to 1950 an investor needs to invest under 13 percent of their portfolio in the 3x leveraged ETF. The remaining 87 percent can be invested in bonds, generating ample interest income and adding huge amounts of stability to the portfolio.

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis

While the portfolio generally lagged a bit in uptrending periods (don’t forget that stock exposure is sitting at 13 percent x 3—somewhere around 39 percent), the portfolio suffered a peak drawdown of just 20.9 percent. That compares with a 35.5 percent drawdown for the standard 60/40 portfolio.

Daily leveraged funds in small, carefully sized doses add to the safety of portfolio. Smaller drawdowns, less volatility, and less money exposed to risky assets.

What are you willing to risk by avoiding leveraged ETFs for the long haul?

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