Some people may look at leveraged ETFs and think they are the best way to get long-term returns. However, if you look S&P 500 An average increase of 10% per year, why not put your money in it Direxion Daily S&P 500 Bull 3x Shares ETF(NYSEMKT: SPXL ) And turn it into 30% a year?
Because that’s not how it works, and if you buy and hold these leveraged ETFs with that intention, it’s good that you could be doing serious unintended damage to your portfolio.
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Leveraged ETFs are designed for one-day returns, nothing more. As I’ll show in a moment, if you hold it for longer than that, you can experience a wide range of returns. In most cases, this will not be a good thing.
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When you invest in a leveraged stock ETF, ie Direxion Daily Semiconductor Bull 3x Shares ETFyou’re not actually investing in stocks.
You invest in derivative contracts, such as swaps or futures, that are designed to provide multiple exposures to the underlying security or index. For example, in the case of this ETF, it aims to deliver 300% of daily returns. NYSE Semiconductor Index.
Note that I said “daily returns.” At the end of each trading day, the profit is withdrawn and the process is repeated. It is important to emphasize that leveraged ETFs are designed for a one-day holding period only. Given the high level of volatility that also comes from using leverage, they are only suitable for aggressive traders and speculators.
This can be read as a warning to many. But for some, that’s part of the appeal. If you have high confidence Nvidiafor example, will beat its quarterly earnings expectations and you think the stock will go up, you might want to trade on a day Direxion Daily NVDA Bull 2x Shares ETF. If you are right, you can double the performance gains of this day.
Of course, the opposite will be true if you are wrong. Leveraged ETFs are therefore only suitable for those with a real stomach for risk.
While ETFs can be useful for day traders, the two biggest risks to them are timing and volatility.
Leveraged ETFs usually come with high expense ratios, sometimes 1% or more per year. Additionally, there is a cost of funds that comes with setting up and setting up each trading day. These costs create a drag on performance. And that drag grows when you keep one of these products.
Degradation of instability may be the greatest enemy of all. Let’s look at a hypothetical example of how high volatility can hurt returns over the long term.
the day
Daily return
Total return
3x daily returns
3x total return
– 3x daily returns
-3x total return
Day 1
+2%
+2%
+6%
+6%
-6%
-6%
Day 2
-5%
-3.1%
-15%
-9.9%
15%
+8.1%
Day 3
+4%
+0.8%
+12%
+0.9%
-12%
-4.9%
Day 4
-7%
-6.3%
-21%
-20.3%
+21%
+15.1%
Day 5
+9%
+2.2%
+27%
+1.2%
-27%
-16%
Data source: Author’s example
In the “Daily Return” column, we see that the following security has experienced significant changes over the past five trading days. The “3x Daily Return” and “-3x Daily Return” columns show how the leverage of the ETF should approximate the expected return for that day.
However, the cumulative return columns show how returns can be affected over time.
If you held this stock correctly, you would have experienced a gain of 2.2% in a five-day period. The 3x leveraged ETF actually ended up returning just 1.2% over the same time frame while it had three times the daily gain and positive returns of the underlying stocks. The -3x leveraged ETF ended up losing 16%, more than it might have expected.
This is the risk of holding leveraged ETFs for longer time frames. For a day, they can be very useful. Any longer than that and your potential return range can be very wide.
At a basic level, leveraged ETFs are only suitable for those who plan for a trading day and want to take significant short-term risk. They can be useful for traders who make a high-stakes bet on an event, such as an earnings or economic report.
However, for many, simply buying and holding stocks, bonds, and ETFs is the best way to go.
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David Dierking has no position in any of the stocks mentioned. The Motley Fool has and recommends positions in Nvidia. Motley Fool has a disclosure policy.
Leveraged ETFs are designed to be aggressive and speculative. This is both appealing and dangerous. Originally published by Motley Fool
