Are Leveraged ETFs Worth the Costs and Risks?

Leveraged ETFs are often marketed as tools to amplify returns for short-term traders. However, they come with a high level of risk and cost that can often outweigh their benefits for long-term investors. Leveraged exchange-traded funds (ETFs) are designed to multiply the returns of an underlying index by using financial derivatives and debt. Some offer two or three times the exposure to the daily performance of the index they track. For example, if the S&P 500 rises by 1%, a 2x leveraged S&P 500 ETF would aim to rise by 2%, and a 3x fund would target a 3% increase.

But the key to understanding these ETFs is recognizing that their leverage works both ways. If the index declines, losses are magnified accordingly. This creates a unique set of challenges for investors who might be tempted by the promise of outsized gains. Leveraged ETFs, while attractive in theory, often lead to significant losses, particularly if held over long periods due to the effects of compounding and market volatility. The more volatile the market, the more likely a leveraged ETF will deviate from its intended multiple.

Costs and Fees: An Unseen Burden

One of the primary drawbacks of leveraged ETFs is their cost structure. These funds tend to have higher expense ratios than traditional ETFs, often exceeding 1%, compared to a typical broad-market ETF which might charge only 0.1% or less. The higher costs are attributed to the complex nature of maintaining the leverage, as the fund managers need to continually rebalance the portfolio to maintain the target leverage ratio.

Beyond the listed expense ratio, there are hidden costs tied to the derivative instruments these funds rely on. Swaps, futures contracts, and other tools used to create leverage have their own associated costs. Over time, these costs erode returns and can lead to underperformance, even if the underlying index performs well.

Decay and Volatility Drag: The Hidden Risk

A key factor in the potential underperformance of leveraged ETFs is the impact of volatility drag or decay. These funds reset daily, meaning that they aim to achieve their target multiple on a daily basis. Over longer periods, the path the market takes becomes critical. In a stable, steadily rising market, a leveraged ETF may track its index fairly well. However, in a volatile market with frequent ups and downs, the compounding of daily returns can cause significant divergence from the intended multiple over time.

Consider the following example:

Day	Index Return	2x Leveraged ETF Return	Cumulative ETF Return
1	+5%	+10%	+10%
2	-5%	-10%	-1%
3	+5%	+10%	+8.9%

Despite the index returning to near its original level after three days, the leveraged ETF has failed to recover fully due to the compounding of daily losses and gains. This effect becomes more pronounced over longer periods of time, especially during volatile market conditions.

Who Should Consider Leveraged ETFs?

Leveraged ETFs are not designed for the average buy-and-hold investor. Their high costs, potential for significant losses, and compounding issues make them unsuitable for long-term investments. These funds are more appropriate for sophisticated traders with a high tolerance for risk who can actively manage their positions and respond to market changes quickly.

Day traders or very short-term traders might benefit from leveraged ETFs if they correctly predict market movements and exit their positions before volatility erodes their gains. However, for most investors, the potential downsides far outweigh the allure of amplified returns.

Historical Performance: Lessons from Past Market Crashes

During market downturns, the risks of leveraged ETFs become glaringly apparent. For instance, during the COVID-19 market crash in March 2020, many leveraged ETFs suffered catastrophic losses. Some even had to liquidate their assets due to the extreme volatility, leaving investors with significant losses. Such instances underscore the inherent risks of these products during periods of heightened market uncertainty.

One particularly infamous example is the Direxion Daily Energy Bull 3x Shares (ERX), which lost over 90% of its value during the 2020 crash. Investors who held the ETF over that period were left with practically nothing, demonstrating how dangerous these funds can be in a volatile market.

Conclusion: Are Leveraged ETFs Worth It?

While leveraged ETFs offer the potential for amplified gains, they come with a significant trade-off in the form of high costs, volatility drag, and increased risk. For the average investor, these risks outweigh the potential rewards, making leveraged ETFs a poor choice for long-term investment strategies.

Short-term traders with a solid understanding of market dynamics and the ability to manage risk may find these tools useful, but even then, the costs and risks must be carefully weighed. If you’re not prepared to actively monitor your investments and handle potentially large losses, it's better to stick with traditional ETFs.

The bottom line is that while leveraged ETFs can provide exciting opportunities for the right type of investor, they are not for everyone. The high costs and risks make them a niche product best suited for experienced traders with a specific short-term strategy in mind. For long-term investors, the safer and more cost-effective route remains a well-diversified portfolio of low-cost index funds.