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What are Leveraged ETFs?

Let’s say you don’t want to buy a GIC or open a high-interest savings account because you think the stock market will go up over the next few years. You already have an online brokerage account so your first instinct is to buy an exchange-traded fund (ETF) that tracks the performance of the market (ETFs, as a reminder, hold a basket of shares that are representative of a sector or index).

But then you come across something you think is better: An ETF that promises to deliver two times the daily return of the market. If the market goes up 1%, this fund will rise 2%, and if the market happens to fall 1%, it’ll decline 2%. The second possibility doesn’t concern you because you’re bullish and expect the market to rise.

So let’s assume you buy this ETF. Over the next month, the market sort of does nothing. It’s very volatile but it ends up basically where it started. You’re a buy and hold investor so you don’t check the market very often. But when you open your monthly statement, this 2x ETF you bought has actually gone down!

Welcome to the scary world of leveraged ETFs.

In recent years, some fund companies have devised ETFs, such as the one described above, that aim to double or even triple the daily movements of a particular index.

Some investors, seeing these products advertised, understandably believe it’s better to buy and hold a leveraged ETF rather than just buy the underlying index.

What they don’t realize is that these vehicles should only be used by active traders on a very, very short-term basis.

Here’s why: Assume that you buy one of these 2x ETFs, and then for the next six trading days, the market alternates between going up 1% and then down 1%. For the sake of simplicity, say the ETF starts at $10. This is what will happen:

  • On the first day, the ETF rises to $10.20. That’s a 2% gain from it’s starting point.
  • On day two, with the market down 1%, the ETF falls 2%. Now it stands at $9.996.
  • On day three, the market is up 1% again. The ETF tacks on 2% to $9.996, leaving it at $10.196.
  • On day four, the market falls 1%. The ETF loses another 2%, so it falls to $9.992.
  • On day five, the market rises 1%. The ETF increases to $10.192.
  • And finally, on day six, the market falls 1%, sending the ETF down to $9.988.

Granted, the numbers here aren’t dramatic, but with only six days of trading (and a flat market), this leveraged ETF has already started to lose money. As you can see, as time goes on, it starts to move further away from the $10 starting price.

It’s all because of a process known as decay. Essentially, as in the example above, the down days have a greater effect on the ETF than the up days. This makes sense: The down days begin with a higher price, so the hit to the ETF is larger compared to the up days, which begin with a lower price. If a market is very choppy, as in our case study, the index value can be volatile but the ETF will gradually lose value.

Of course, this is just one possible outcome. There’s a better outcome and a much worse outcome.

The ideal outcome is that you buy one of these leveraged ETFs right before a market soars (or falls, if it’s a bearish ETF which does well if the market falls).

So if you buy a 2x ETF on the Toronto Stock Exchange and it goes up 10% in short order, you could make a fair amount of money. In this scenario, where there are many up days and few down days for the ETF, the gains will compound on each other. It’s for this reason that active traders have flocked to these products.

Mind you, the opposite result is hazardous to your portfolio. If you buy a “bullish” 2x ETF and the market goes straight down, your losses will be amplified. Every day the market sinks, your ETF will sink by twice as much (and the losses will feed on themselves).

Granted, the companies that offer these products do say they’re only meant to track the daily changes in an index. And they cover themselves in the fine print.

But many investors seem to think they’re, well, investments.

They’re not. They’re really risky trading vehicles and they can leave you with an unpleasant surprise.

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Flickr: Andreas Poike