How Leveraged ETFs Work

A recent Wall Street Journal article highlighted the incredible success of leveraged ETFs. A year ago, none existed; today, more than 50 such funds collectively hold more than $6 billion in assets. Through the magic of borrowing money, these funds can provide investors with additional leverage to invest in the market and allow investors the opportunity to hedge their portfolios, even in down markets, making them especially attractive in tough years.

The conception of Leveraged ETFs

Leveraged ETFs are exchange-traded funds that are based upon well-known indexes, but that provide investors with additional leverage by using borrowed money. Their goal is to increase the return of the underlying index and provide a better return for the fund’s investors. Typically they provide $1 of debt for every $1 of investor equity, and are marketed as 2X funds.

The problems of Leveraged ETFs

One problem of leveraged ETFs is that many investors misunderstand how leveraged ETFS work. A widely held misconception about these funds is that they will offer twice the return of the underlying index, which means that if the S&P 500 returns about 10% a year, then the SSO should return 20%. But that’s not true, because these funds only double the daily return, and there’s a big difference between doubling the daily return and doubling the annual return. Let’s say that one day the market goes up 10%, and the next day it falls 10%. The two-day loss for the index is 1%, but the loss for the leveraged fund is 4%. Here’s why:

Index: (1 + 10% ) x (1 – 10%) = 1.1 x 0.9 = 0.99, 1% loss
X2 Fund: (1 + 20%) x (1 – 20%) = 1.2 x 0.8 = 0.96, 4% loss

Thus over a two day period, this fund’s losses are 4x the amount of the index, not 2x. This example comes from the ProShares prospectus, and is a clear indication that investors in 2X funds should not expect their investment to provide double the return of the S&P 500 for any period longer than one day.

In addition, the folks running these leveraged funds must constantly buy and sell shares of the underlying index, or futures contracts and other derivatives, to keep their leverage ratios in line. This buying and selling activity increases the underlying volatility, and can lead to huge sell-offs in down markets that are impossible to recover from in the next bull market. Moreover, the turnover increases expenses and transaction costs, eroding investors’ ultimate returns.