Many professional traders, analysts and investment managers love to hate leveraged exchange-traded funds (leveraged ETFs), funds that uses financial derivatives and debt to amplify the returns of an underlying index. However, ETFs don't always work the way you may expect, based on their names (which often feature the terms "Ultra Long" or "Ultra Short"). Many people who look at the returns of an ETF, compared with its respective index, get confused when things don't seem to add up. Investors should know the following factors when considering this type of ETF. 

How They Work (or Don't)

If you look into their descriptions they promise two to three times the returns of a respective index, which they do – sort of. Leveraged ETFs boost results, not by actually borrowing money, but by using a combination of swaps and other derivatives. Let's look at a few examples of how ETFs don't always work the way you would expect.

The ProShares Ultra S&P 500 (SSO) is an ETF designed to return twice the S&P 500. If the S&P 500 returns 1%, the SSO should return about 2%. But let's look at an actual example. During the first half of 2009, the S&P 500 rose about 1.8%. If the SSO had worked, you would expect a 3.6% return. In reality, the SSO went down from $26.27 to $26.14. Instead of returning 3.6%, the ETF was essentially flat.

It's even more troubling when you look at the SSO along with its counterpart, the ProShares Ultra Short S&P 500  (SDS), which is designed to return twice the opposite of the S&P 500. Over the 12 months ending June 30, 2009, the S&P 500 was down nearly 30%. The SSO behaved pretty well and was down about 60%, as you would expect. The SDS, however, was down about 20%, when it should be expected to be up 60%! (Learn more in "Dissecting Leveraged ETF Returns.")

Why the Gap?

So now that we've looked at a few examples of how ETFs don't always do what they are supposed to do, let's examine why. ETFs are really designed and marketed to track the daily movements of a corresponding index. You may ask yourself why that would matter, since if it tracks its index properly each day, it should work over any extended period of time. That is not the case.

One reason is the expense ratio. The most popular leveraged ETFs will have an expense ratio of 0.95%, which is considerably higher than the average expense ratio of 0.46% for all ETFs across the board. This high expense ratio is basically a management fee, and it will eat into your profits and help exacerbate your losses. (For more, see "Leveraged ETFs: Are They Right for You?")

Leverage Reset

A high expense ratio is at least transparent. What many investors don’t recognize is that leveraged ETFs are rebalanced daily. Since leverage needs to be reset on a daily basis, volatility is your greatest enemy. This probably sounds strange to some traders. In most cases, volatility is a trader’s friend. But that's certainly not the case with leveraged ETFs. In fact, volatility will crush you. That’s because the compounding effects of daily returns will actually throw off the math, and can do so in a very drastic way.  

For example, if the S&P 500 moves down 5%, a fund like the SSO should move down 10%. If we assume a share price of $10, the SSO should be down to about $9 after the first day. On the second day, if the S&P 500 moves up 5%, over the two days the S&P 500 return will be -0.25%. An unaware investor would think the SSO should be down 0.5%. The 10% increase on day two will bring shares up from $9.00–$9.90, and the SSO will, in reality, be down by 1%. It decreases a full four times the decline of the S&P 500.

Typically, you will find that the more volatile the benchmark (the S&P 500 in this example) for a leveraged ETF, the more value the ETF will lose over time, even if the benchmark ends up flat or had a 0% return at the end of the year. If the benchmark moved up and down drastically along the way, you may end up losing a significant percentage of the value of the ETF if you bought and held it. For example, if a leveraged ETF moves within 10 points every two days for 60 days, then you will likely lose more than 50% of your investment.

Compounding works to the upside and the downside. If you do some research, you will find that some bull and bear ETFs that track the same index both perform poorly over the same time frame. This can be very frustrating to a trader, as they don’t understand why it’s happening and deem it unfair. But if you look closer, you will see that the index being tracked has been volatile and range-bound, which is a worst-case scenario for a leveraged ETF. The daily rebalancing must take place in order to increase or decrease exposure and maintain the fund’s objective. When a fund reduces its index exposure, it keeps the fund solvent, but by locking in losses, it also leads to a smaller asset base. Therefore, larger returns will be required in order to get you back to even on the trade. 

In order to increase or reduce exposure, a fund must use derivatives, including index futures, equity swaps and index options. These are not what you would call the safest trading vehicles due to counterparty risks and liquidity risks.

Investor Inexperience

If you’re a novice investor, don’t go anywhere near leveraged ETFs. They might be tempting because of the high potential returns, but if you’re inexperienced, then you’re much less likely to know what to look for when researching. The end result will almost always be unexpected and devastating losses. Part of the reason for this will be holding on to a leveraged ETF for too long, always waiting and hoping for things to turn around. All the while, your capital is slowly but surely being chewed away. It’s highly recommended that you avoid this scenario.

If you want to trade ETFs, then begin with Vanguard ETFs, which often have low betas and extremely low expense ratios. You might not have a profitable investment, but at least you won’t have to worry about your capital withering away for no reason. (For more, see "Guide to ETF Providers: Vanguard.")

Long-Term Investing Risk

Up until this point, it’s obvious that leveraged ETFs are not suited for long-term investing. Even if you did your research and chose the right leveraged ETF that tracks an industry, commodity or currency, that trend will eventually change. When that trend changes, the losses will pile up as fast as the gains were accumulated. On a psychological level, this is even worse than jumping in and losing from the get-go, because you had accumulated wealth, counted on it for the future, and let it slip away.

The simplest reason leveraged ETFs aren’t for long-term investing is that everything is cyclical and nothing lasts forever. If you’re investing for the long haul, then you will be much better off looking for low-cost ETFs. If you want high potential over the long haul, then look into growth stocks. Of course, don’t allocate all of your capital to growth stocks – you need to be diversified – but some allocation to high-potential growth stocks would be a good idea. If you choose correctly, you can see gains that far exceed that of a leveraged ETF, which is saying a lot. 

Leveraged ETF Potential

Is there any reason to invest in or trade leveraged ETFs? Yes. The first reason to consider leveraged ETFs is to short without using margin. Traditional shorting has its advantages, but when opting for leveraged ETFs – including inverse ETFs – you’re using cash. Therefore, while a loss is possible, it will be a cash loss, no more than what you put in. In other words, you won’t have to worry about losing your car or your house.

But that’s not the biggest reason to consider leveraged ETFs. The biggest reason is high potential. It might take longer than expected, but if you put the time in and study the markets, you can make a lot of money in a short period of time by trading leveraged ETFs.

Remember how volatility is the enemy of leveraged ETFs? What if you studied and understood the markets so well that you had absolute conviction in the near-future direction of an industry, commodity, currency, etc.? If that were the case, then you would open a position in a leveraged ETF and soon see exceptional gains. If you were 100% certain about the direction of what the leveraged ETF was tracking and it happened to depreciate for a few days, then you could add to your position, which would then lead to an even bigger gain than originally planned on the way up. (For more, see: "Inverse ETFs Can Lift a Falling Portfolio.")

However, the best way to make money with leveraged ETFs is to trend trade. V-shaped recoveries are extremely rare. That being the case, when you see a leveraged or inverse ETF steadily moving in one direction, that trend is likely to continue. It indicates increasing demand for that ETF. In most cases, the trend won’t reverse until the buying becomes exhausted, which will be indicated by a flat-lining price.

Some investors will scoff at this notion, which is fine. I look at it this way. If I stick to traditional investing, I might see a return, and it will take a long time to play out. With leveraged ETFs, I’m 95% confident in my positions and will see a much higher return in a shorter period of time. This isn’t complicated, but it’s certainly not recommended for the average retail investor.

The Bottom Line

If you’re a retail investor and/or a long-term investor, steer clear of leveraged ETFs. Generally designed for short-term (daily) plays on an index or sector, they should be used that way, otherwise, they will eat away at your capital in more ways than one, including fees, rebalancing, and compounding losses.

If you’re a deep-dive researcher willing to invest full days to understanding markets, then leveraged ETFs can present a great wealth-building opportunity, but they're still high-risk. Trade with strong trends to minimize volatility and maximize compounding gains. (For more, see "Understanding Taxation on Leveraged ETFs.")

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.