Why daily resets make leveraged ETFs unsuitable as long-term investments.
In the past, if an investor was very confident of the direction they expected the market to go they would borrow. This would allow them to increase what they could invest, in the hope of amplifying their expected return. That still happens. But in recent years ETF providers have been able to create an easier way for investors to do this, through the use of so-called leveraged ETFs.
While these products provide returns as if the investor had borrowed, they instead use complex instruments such as equity swaps and options to replicate the return of what is being invested multiplied by a targeted amount. The results, however, are the same as borrowing: amplified losses and gains.
One example of this is the WisdomTree Silver 2x Daily Leveraged ETC (LSE:LSIL). This leveraged ETF aims to provide a return that is double the daily price movement of silver, using the Bloomberg Sub Silver index as its price benchmark. This means that if the index goes up 5% one day, the fund should go up 10%. Conversely, if the index drops 5%, it drops 10%.
Any investor buying this will be highly confident of the direction of silver. As well as commodities, such as gold and oil, leveraged ETFs are often used to provide exposure to major indices. For example, among interactive investor’s most popular ETFs is WisdomTree FTSE100 3x Daily (LSE:3UKL), which, as the name suggests, provides triple leveraged exposure to the FTSE 100 index. L&G FTSE 100 Leveraged Daily 2x ETF (LSE:LUK2) is also a popular option.
Also available on the interactive investor platform are several US index-focused leveraged ETFs such as the WisdomTree NASDAQ 100 3x Dl Lvrgd ETP (LSE:QQQ3) and the Xtrackers S&P 500 2x Leveraged Daily Swap (LSE:XS2D).
This may strike investors as a highly appealing proposition. As every investor should know, the US market has historically provided an annualised return of somewhere between 7% and 10%, depending on how you measure it. While volatility exists, the long-term trend for markets, particularly in the US market, is up. So why not buy an ETF that just triples that return?
Unfortunately for investors, it is not that simple. Investors should note that many of the leveraged products have the word “daily” in their title. That is there for a reason. In order to keep their leveraged ratio fixed, the ETFs in question have to rebalance every day. This means the ETF aims to provide double or triple the daily performance of the underlying asset.
As a result, investors cannot expect to simply receive triple the 10-year performance of the index in 10 years’ time. Instead, providing the leveraged daily returns changes the maths.
So, for example, let’s compare two investors, each investing £100 in both an ETF that tracks the FTSE 100 (called Normal FTSE 100 ETF) with a triple leveraged ETF that tracks the FTSE 100, called 3x FTSE ETF.
If the FTSE 100 were to go up by 10% on the first day, the investor in the Normal FTSE 100 ETF would receive a return of 10%, giving them £110 at the end of the day. The investor in the 3x FTSE 100 ETF would see a 30% return, giving them £130. That is how it is supposed to work and the 3X FTSE 100 ETF investor is feeling pretty happy.
However, on the next day the FTSE 100 falls by 9%. That brings our Normal FTSE 100 ETF investor back to £100, where they started. However, for our 3X FTSE 100 ETF investor, that 9% fall multiplied by three is substantially larger, leading to a 27% fall, bringing their investment to £95. While only £5 below their starting price, it is £35 below what they previously had, making it a substantial one-day fall.
Unfortunately, on the third day, the market falls by another 5%. This results in our Normal FTSE 100 ETF falling to £95. However, that 5% means a 15% fall for the 3x FTSE 100 ETF, bringing it to £81.
As you can see, the difference in holdings between the two ETFs is now significant. While a good day on the market meant the leveraged ETF enjoy huge gains, that was all wiped out and more in a bad day, then further amplified by one more bad day.
But what if, after a few good days, the index should recover - will the 3x FTSE ETF recover quicker thanks to multiplying gains by three? This could play out, but the large movements down matter, as large losses are harder to recover from. For example, a loss of 10% requires a gain of 11% to break even; a loss of 20% requires a gain of 25%; a loss of 33% requires a gain of 50%; and a loss of 50% requires a gain of 100%.
So, in our above example, by the end of the third day the 3x FTSE 100 ETF investor has £81, meaning they are 19% down from the £100 investment. In contrast, our Normal FTSE 100 ETF is just 5% down. Even with the amplification of returns, it takes more work for the leveraged ETF to get back to break-even.
To get back to £100 by day four, our Normal FTSE 100 ETF will need to see gains of 5.26%. However, that gain, multiplied by three, would not be enough to get our 3x FTSE 100 ETF to break-even by the end of the day. In order to recover their losses by the end of day four, our 3x FTSE 100 ETF investor would need to see gains of 23.46%. That would require a higher underlying price movement than just 5.26%.
So the longer you hold a leveraged ETF, the further the ETF’s performance will diverge from the underlying market or normal ETFs tracking them, with larger losses increasingly hard to recover from. This is often called “decay” and is the principle reason why leveraged ETFs are not suitable as long-term investments.
Indeed, this warning against using such ETFs for more than a day is noted in the prospectus of most leveraged ETFs. L&G FTSE 100 Leveraged Daily 2x ETF, for example, says in its Key Information Document (KID) that: “As the index rebalances daily, the fund may not be a suitable investment for periods of longer than one day.”
The KID of Xtrackers S&P 500 2x Leveraged Daily Swap UCITS ETF is even more explicit. It notes: “The index is designed to do this on a daily basis only, which should not be equated with seeking a leveraged position for periods longer than a day. The performance of the fund over periods longer than one day will not be correlated or symmetrical with the returns of the underlying index.”
Given such risks, many financial commentators are vehemently against the use of such products altogether. Kenneth Lamont, passive funds research analyst at Morningstar, says: “Given the complexity and elevated risk profile of these products, we do not think they are suitable for most retail investors.” Similarly, Josh Brown, chief executive of Ritholtz Capital Management, has argued: “The words ‘investors' and '3x leveraged’ should never appear in the same sentence.”
Whether investors want to run the risk is their own choice to make. But the important thing to keep in mind is that these products are not to be used as a long-term investment instrument and are suitable only for day traders trying to predict the daily movement of the market.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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