Is it True Can Leveraged ETFs Not Be Held Long Term?
Executive Summary
- Leveraged ETFs exaggerate the pattern of the underlying investment.
- We cover the common quotes that state this is not good for long-term investing.
Introduction
Leveraged ETFs allow an investor to make a bet on a trend that they have high confidence in. However, the problem is that they cannot be held long-term, yet timing when a trend manifests is improbable to do. At first, glance leveraged ETFs appear like a good substitute for buying options, which of course expire.
This is explained in the following quotation.
Leveraged ETFs can’t buy and hold anything — they create positions using futures contracts. – Reddit
Which is then countered by this comment.
Leveraged etfs can and do hold something, which you pointed out, futures contracts. theyre not burning cash, they rebalance to nav at the end of each day. a 3x fund will not “basically always” decay in value, look at SPXL: 3x SPY, no decay there.
If you want to hold a leveraged investment, thats fine but a 3x daily resetting is the worst way to do it, you would want to hold something that resets on a monthly or quarterly basis, or just hold the futures contracts directly and set aside enough cash to achieve your desired leverage.
*https://www.reddit.com/r/investing/comments/nm50u3/are_leveraged_inverse_etfs_truly_as_evil_as_web/
Therefore it is disappointing to many to learn that leveraged ETFs must be traded out of relatively quickly.
Most of the quotes about leveraged ETFs are negative. However, some of the articles I will cover on leveraged ETFs appear to leave out important features of leveraged ETFs.
From The Truth About ETFs
This quote is from the book of the title above.
Dynamic funds are not designed to be held for long periods of time because of the cost of leverage easts away at the value. I have not found dynamic funds profitable in my historical simulations and so do not use them.
This brings up the question of how much borrowing money to obtain leverage actually costs that it can drive down returns. It places leveraged ETFs into the timing category as an investment.
From Investopedia
If you look into the descriptions of leveraged ETFs, they promise two to three times the returns of a respective index, which they do, on occasion. 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.
This quote explains that the cost is actually from buying derivatives.
The quote continues.
Compounding works on the upside and the downside. If you do some research, you will find that some bull and bear ETFs that track the same index performed 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.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.
That is interesting. However, that also limits the ETFs for an investor.
Reasons to Use Leveraged ETFs
But that’s not the biggest reason to consider leveraged ETFs. The biggest reason is the 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, or currency?
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.
This means the trend needs to break your ways in a few months or so. So again, it requires timing.
The Balance
Some of these quotes are so negative on leveraged ETFs that they border on the bizarre.
Here’s how debt works to amplify returns: say you borrow $1,000 at a 4% interest rate. You use that money and $100 of your own funds to buy a stock. You have $1,100 invested at that time. If the price goes up 1% in one day, the stock is worth $1,111. You could pay off the $1,060 owed to the broker and have $51 leftover. Since you only invested $100, a 1% price rise resulted in a $51 gain.
https://www.thebalance.com/leveraged-etfs-for-beginners-357490
It’s not clear that ETFs use debt. Rather they buy options or derivatives. There are fees for these options or derivatives.
If the stock price dropped 1%, the stock would be worth $1,089. You’d need to pay the $1,060 to the broker; you’ve also lost $11 of your original $100. Now imagine that you hold that stock for a week, and the price drops 1% every day for five trading days. You have to pay the broker $1,060, but the stock is only worth $1,046. You owe the broker $14, and you lost $100. You’ve taken a $114 loss. You then have to make up that loss in the future in addition to the gains you’re hoping to make.
These simplified examples show you how easy it is to lose money using leverage because stock prices move up and down every day. A 1% drop in a stock’s price is not unheard of. If you buy into a leveraged ETF built to amplify an index, a 1% drop could be devastating because it means many stocks dropped in price.
That last part makes no sense. If a 3x leveraged ETF’s underlying assets drop 1% the ETF itself drops roughly 3%, although there is some variance, there is not a perfect match.
A leveraged ETF also resets itself every trading day to the underlying index.3
This means that if you were to try to buy and hold, you would have your position reduced to zero (under most ordinary volatility conditions). Over time, the mechanics of the ETF itself would strip away all of your funds, even if the market ended up going straight to the moon. This is a nuance lost on many new investors who try to invest in a fund meant for very short-term speculation.
If this were true, there would be no reason for leveraged ETFs to exist, except for short-term trading.
If you’re looking to build wealth, it is simple enough. You buy high-quality blue-chip stocks.
This is amusing because it almost appears that this article from where these quotes were pulled is trying to make a case for stocks by overstating the negatives of leveraged ETFs. If the statement about blue chip stocks is true, then a leveraged ETF, comprised of blue chip stocks should be an even better return.
In reading The Balance’s other articles it is clear that the site specializes in very surface level articles.
This quote is from a comment on a Reddit post on this topic.
A leveraged ETF is great if you can get out before a crash happens. Trouble is, you may not know when a crash will happen. Leverage in general is really tempting, but it burns really badly in a crash.
Quote #2
Leveraged ETF strategies have been backtested for drawdowns starting as far back as 1987. In fact if you held a blend of 3x SPY + treasuries not only would you have significantly outperformed the market but also suffered less of a drawdown during the 2008 crash.
The following video explains the standard narrative regarding leveraged returns.
Quote #3
I have actually run these numbers several different ways going all the way back to early 2000s and I found out a couple things.
The idea that you shouldn’t hold leveraged ETFs long term is largely a BIG FAT MYTH! It is based on lumping together all leveraged funds together. However, if we can all agree on one fundamental market truth, then we can get past this myth. That truth is: The stock market will always go up over the long term.
That in mind, a 2x or 3x inverse fund is guaranteed to lose. Commodity leveraged funds – probably also guaranteed to lose just based on the fact that the funds are using contracts of future contracts and nothing says commodity prices have to always go up over time.
Some people say “But… but… they use future contracts and futures contracts have time value erosion so you never get a real 3x”. Ok, boo-fuckin-hoo. Yes I the market average over the last 20 years has been 10% well your 3x leveraged may average 22%. That’s just the way the number work out over the long run because of maths or some shit. Doesn’t matter its still way better than dollar cost averaging into a regular index fund.
*https://www.reddit.com/r/investing/comments/oor59b/eli5_why_shouldnt_you_hold_leveraged_etfs_long/
This is explained in more detail in the following paper Leverage for the Long Term.
While we cannot conclude that the daily leveraged always outperforms in an upward trending market, the idea that leverage is only suitable for very short-term trading is false when looking at how daily leveraging can perform over long-term cycles. That is not to say that leverage is without risk, just that the source of that risk does not come from some inherent decay. – Leverage for the Long Term
Second Article on ETFs
What is often forgotten, is that the daily resetting also helps and serves as protection in some cases. Let’s take an example where the underlying drops 10% four days in a row:
Underlying: 100 -> 90 -> 81 -> 73 -> 65 – 35% loss
3x Leverage: 100 -> 70 -> 49 -> 35 -> 24 – 76% loss
A 76% loss is a lot less than 3x of 35% loss. If it did not reset daily, the leveraged portfolio would be wiped out as 35*3 = 105% loss!
The same is also true when the underlying increases multiple days in a row:
Underlying: 100 -> 110 -> 121 -> 133 -> 146 – 46% gain
3x Leverage: 100 -> 130 -> 169 -> 220 -> 286 – 186% gain
A 186% gain is a lot better than the expected 46*3 = 138% gain.
There is not a single 30 or 40-year timeframe since 1927 where DCAing into either 2x SPY or 3x SPY lost money compared to just buying SPY, even when holding through the depression in the 1930s, 1970s stagflation, the lost decade from 1999 to 2009, or ending the period at the bottom of the Covid-19 crash.
Past performance does not guarantee future results and all that stuff, but it does seem like having at least a portion of your portfolio in leveraged index funds is a great way to increase wealth, with the rewards heavily outweighing the risks. The hard part is having to stomach watching the extreme portfolio drawdowns during market corrections.
*https://www.reddit.com/r/investing/comments/ooxu94/debunking_the_leveraged_etfs_are_not_a_longterm/
Reddit on the Overselling of Problems With Leveraged ETFs
I am not the only one to note the overly negative aspect of articles on leveraged ETFs. The following quotation explains this.
Some of these articles make it sound like some tooth fairy is going to emerge from the ethos and steal all the capital you have in your account. As if your position is just going to permanently vaporize forever.
I have invested in some inverse leveraged ETFs, and their performance over the last however many years has been just fine. If I buy the ETF at a low market price, why would it not eventually go back up, as it has cyclically over the course of maybe 10 years or more?
Is there something going on that is going to take money out of my position and steal some of the shares I own? Is the ETF somehow withdrawing cash from my positions?
Or is the concern limited to the simple performance of the fund? It would seem to me if the ETF itself has a long and successful track record of matching the movements of the underlying asset, why not buy low and sell high months down the road even if the ETF is meant to track daily movements?
*https://www.reddit.com/r/investing/comments/nm50u3/are_leveraged_inverse_etfs_truly_as_evil_as_web/
Diversified Leveraged ETFs
One thing left out of the analysis of leveraged ETFs is that many of the people who offer up the negatives of leveraged ETFs seem to assume is that the investor will only hold one leveraged ETF. This leaves out the fact that one can hold a diverse combination of ETFs. Some of these leveraged ETFs can be inverse and some standard or pro. The importance is the performance of the overall portfolio, not the performance of a single ETF.
This occurred to the author first but then appeared in a comment after I had come to this conclusion.
I have backtested the performance of 2x and 3x leveraged (not inverse) ETFs with over 40 years of daily data. I’ve also written a post about it. The results clearly show that leveraged ETFs can definitely be great long term investments as long as the underlying index is broadly diversified. I invest in leveraged ETFs myself now. Leveraged ETFs (and leveraged investments in general) are terribly misunderstood. Even well-respected sources often just write them off due to “decay”, which is quite short-sighted.
*https://www.reddit.com/r/investing/comments/nm50u3/are_leveraged_inverse_etfs_truly_as_evil_as_web/
The Multiple Outcomes in an Investment
Stock markets usually have few ways to perform.
Drop > Rise
Rise > Drop
Rise > Rise More
Drop > Drop More
However, people tend to and love to just talk about situations 1 and 2, which is “drop then rise” and “rise then drop”. They forget about the existence of the other two. In fact, 3 and 4 would very likely happen because the probability is 25% for the four options. – Reddit
LETFs Versus Buying on Margin
The following quote explains this advantage.
LETF’s have the advantage that you can’t be margin-called. Instead of buying actual stocks and borrowing money to buy double, they buy future contracts and swaps at banks, that promise to pay the returns with a factor of 2 or 3 for example. This obviously leads to relatively high cost. Especially during highly volatile markets. Due to their nature, they can only replicate precise 2x or 3x exposure if you buy and sell them daily. There is a lot of discussion that this “time decay” effect might not be so relevant in certain scenarios and could be viable long term. They also introduce “counter-party risk”, since you have to trust that the banks who sold those contracts to your fund don’t go bankrupt. – Reddit
The following contains information as to why many of the arguments around LETFs are false.
*http://www.ddnum.com/articles/leveragedETFs.php
Paper on Leveraged ETFs
Under academic theory, one cannot develop a strategy to time the use of leverage due to market efficiency and the randomness of security prices. We find strong evidence to the contrary. Security prices are non-random and tend to exhibit trends over time as well as volatility regimes under which leverage is more or less beneficial. As such, one can combine these two concepts to create a strategy that employs the use of leverage only during periods which have a higher probability of success. In doing so, one can achieve higher returns with less risk than a comparable buy and hold strategy. This is the primary focus of our paper: systematically determining environments favorable to leverage and developing a strategy to exploit them.
In this paper, we propose that using widely-referenced Moving Average indicators for evaluating stock market trends can enhance absolute return and generate higher risk-adjusted performance beyond what the CAPM and Modern Portfolio Theory would argue is possible. -*Paper Link – Leverage For The Long Run
This paper concludes that there are times when leverage can be very assistive in obtaining high returns.
Conclusion
There are a number of leveraged ETFs that have performed quite well. Secondly, there is a pattern of those that observe the negatives of leveraged ETFs only pointing to downsides like the cost of buying options to maintain leverage, rebalancing, and the downside leverage. For example, if we just take rebalancing it has a second effect.
Leverage is generally misunderstood. It does work both ways as pointed out. If you leverage a bad investment and rebalance frequently you will lose a ton. If you leverage a good investment and re-leverage frequently you can actually add to the returns because you are compounding on compounding. This can all be confusing but it is a basic idea in finance.
*https://www.reddit.com/r/investing/comments/ooxu94/debunking_the_leveraged_etfs_are_not_a_longterm/
However, what other tool is there that is better to apply leverage to a sector? It seems as if primarily the negatives of leveraged ETFs are being accounted for. This is covered in the following quotation from the same article.
Damn you OP, why did you need to make this post? More people in leveraged ETFs will increase volatility, increasing the volatility drag effect to untenable levels, ruining the entire thing. It’d be more beneficial for the masses to stay with their heads in the mud, let them think it’s too dangerous.
And this quote in response.
The masses aren’t going to read that post.