Investors face substantial risks investing in all leveraged exchange-traded funds (ETFs), but especially 3x ETFs, due to the higher degree of leverage used. Leveraged ETFs may be useful for short-term trading purposes. However, most investors underestimate the downsides of leveraged ETFs. They are not appropriate for long-term investments. Consider these key risks before investing in 3x ETFs.

Compounding

The effect of compounding is a major risk for leveraged ETFs. Compounding is the cumulative effect of applying gains and losses to a principal amount of capital over time. This mathematical concept can cause significant gains or losses in leveraged ETFs.

For example, assume an investor has placed $100 in a 3x fund. The index that the fund tracks goes up 5% a day for two consecutive trading days. The daily percentage increase for the 3x fund is 15% a day. The investment is worth $115 after the first day, and it is worth $132.25 after the close of trading on the second day. The investment is therefore up 32.25% over the two days instead of just 30%. This is a higher return than an investor might expect. While this higher gain might be a temporary advantage, compounding usually does not result in a positive outcome.

Starting with the same initial $100, assume the price of the benchmark index goes up 5% one day and down 5% on the next trading day. The 3x goes up 15% and down 15% on consecutive days. After the first day of trading, the initial $100 investment is worth $115. The next day after trading closes, the initial investment is now worth $97.75. This represents a loss of 2.25% on an investment that would track the benchmark without the use of leverage. Volatility in a leveraged fund can quickly lead to losses for an investor.

Daily Resets

Most leveraged ETFs reset their exposure to the underlying benchmark index on a daily basis. These ETFs generally track the daily movements in their benchmark indexes. The exposure is reset on a daily basis, which can impact returns over multiple trading sessions. In movements that oscillate up and down, the returns for leveraged ETFs are lower than what investors expect. This is related to the concept of compounding. While leveraged ETFs may perform well in directional markets, they do not perform well in choppy markets. Markets are often choppy, thus reducing the effectiveness of leveraged ETFs.

Use of Derivatives

Many 3x ETFs use derivatives to provide their daily performances. These funds may use futures contracts, swaps or options to provide the increased exposure to the benchmark being tracked. Swap agreements are customized agreements with a counterparty for the exchange of cash flows over time, based upon the movement in the index.

For example, in a swap agreement for an equity index, one party generally pays the cash equal to the index return, while the other party pays a floating interest rate. Investors face the risk of a default by the counterparty to the agreement. While the likelihood of default is probably minimal, investors should still be aware of this possibility.

High Expense Ratios

The 3x ETFs also have very high expense ratios, which makes them unattractive funds for long-term investors. For example, the VelocityShares 3x Long Crude Oil ETN has an expense ratio of 1.35%. Compare this to the Vanguard Total Stock Market ETF, which has a minuscule expense ratio of 0.05%. This is a difference of 1.3%. For an investment of $50,000 held for a year in each ETF, this would represent $675 more in expense fees for the VelocityShares 3x Long Crude Oil ETN. These high expense ratios have a significant impact on investment returns over time.