In the last part of the series, we have described the main potential issues connected to the holding of leveraged ETFs for a long time – it is so called compounding, or tracking-error, as we say in our fund. When the market is volatile, this phenomenon can wreak havoc on the value of the leveraged instrument.
Just imagine this – we have a non- leveraged ETF, which value is 100, and we will set the same value for the leveraged ETF at the start, then the market moves up 10 points each day and the next day comes back to the original value, and if the situation repeats 20 times in a row, the non-leveraged ETF will, of course, remain at the original value 100, while 2 times leveraged ETFs will lose more than 30% of its value.
But what are the other problems and risks of the leveraged ETFs?
The vast majority of leveraged ETFs perform resets on a daily basis. This means that the leverage and multiplier of potential returns (2x, 3x) are kept just and only on a daily basis. With long-term holding – for weeks, months or even years – the yield may significantly differ compared to the performance of its underlying instrument/ benchmark/index. As I have mentioned above, the difference goes hand in hand with the market volatility.
Due to their design, leveraged ETFs carry a whole range of expenses related to the reset/rebalancing of the portfolio. Therefore, it can be said, that most of these leveraged ETFs are actively managed, which usually means increased costs.
For comparison, ETF: SPY has expense ratio of 0.09%, while a leveraged ETF: SSO has already 0.90%.
Risks associated with derivatives
Leveraged ETFs often use a variety of financial derivatives in their portfolios to increase potential returns. Derivatives – in comparison with a direct, non – leveraged investment – carry a whole range of risks, especially with regard to the use of the leverage. For example, if the underlying asset is significantly weakened, the loss in case of the leveraged derivate could be several times higher. In such situation, the fund may receive a margin call, which means a possible liquidity problem.
The following chart shows how the above-mentioned inefficiencies are involved in the decay, or in other words making a profit from shorting of such ETF: BOIL (2 x leveraged ETF for natural gas, precisely ProShares Ultra Bloomberg Natural Gas). I have mentioned the natural gas effect for example here, but it is obvious that inefficiencies have a significant effect on the erosion of this substrate.
The bottom line is that leveraged ETFs can represent a big attraction for many investors – because of their ability to multiply revenue compare to the traditional non-leveraged instruments. However, as we have already explained, there are indeed many non-negligible risks that an experienced investor should always keep in mind and therefore avoid long-term holding.
Leveraged ETFs are primarily designed for very short-term holding (either intraday or few days as maximum) – for purely speculative purposes (potentially multiplied yields compare to traditional ETFs) or hedging purposes (eg short-term long position with leveraged ETF for volatility instead of classical stop-loss orders, may have a place in the portfolio).
For long-term holding, investors shall instead consider buying traditional non-leveraged ETFs on margin (required margin and thus “leverage” depends on broker’s conditions), enhancing leverage on their positions through call options, etc.
However, we will focus on the opposite technique in the following parts of this series and this is obviously shorting – a speculation on the decline of the leveraged ETFs. Taking into account the huge drops in these instruments (check the example below, 2x leveraged ETF: UVXY – development only within this year!), we need to keep in mind a few important principles and keep the strict rules and trading plans. But that’s for the next time.