Why leveraged ETFs may not be what they seem
Q: I have been looking at investing in a 3x leveraged ETF after my friend said he made a killing in them this past year. They look pretty good, but I just read an article that says leveraged ETFs generally don’t do well. What is the real story?
A: Congratulations to your friend on his successful trade. I am truly glad it worked out so well for him. While he is still flush with excitement from that big win, he might want to read my column from January titled, “Confessions of a Bull Market Genius.” Let me know if you are interested and I’ll be happy to send you a copy.
For those who are new to this part of the market, leveraged ETFs seek to deliver a return equal to a multiple of an index’s daily price change. For example, the Direxion Daily S&P 500 Bull 3x ETF (symbol: SPXL) offers investors 3 times the daily return on the S&P 500 index. In other word, if you own SPXL and the S&P 500 index goes up 5 percent in a day, you should expect to see your position increase by 15 percent. SPXL is a bullish fund, meaning it moves up and down with the market. You can also find bearish funds that move inversely with the market.
A leveraged ETF is rebalanced every day to maintain constant leverage. If you hold the leveraged ETF longer than one day, the daily rebalancing can lead to something called the Constant Liquidity Trap. To illustrate how this works, consider the following two-day example of investing in $10,000 in SPXL. This will take a little math, so hold on.
Day One: You invest $10,000 in SPXL when the S&P 500 index is at 4,200. In order to give you three-times exposure to a change in the index, the fund managers buy $30,000 worth of shares in the underlying index using stock index futures or a line of credit. Let’s assume the index rallies 5 percent on the first day to 4,410. Given the 3x multiple on this fund, your position value will increase by 15 percent to $11,500. At the end of the day, in order to maintain your 3x exposure to changes in the index, fund managers will buy another $4,500 worth of shares in the underlying index (the $1,500 gain in your position value times 3, the fund’s leverage multiple).
Day Two: On the second day, let’s suppose the index drops back to 4,200, the same level where you started, a decline of 4.8 percent. Given the 3x multiple on SPXL, your position value will decline by 14.4 percent to a value of $9,844.
This is the Constant Liquidity Trap. Over two days, the index is unchanged, but your leveraged ETF position has lost $156. Why does it work this way? Because rebalancing the portfolio daily to maintain the fund’s target leverage often results in buying high and selling low.
In 2009, Marco Avellaneda and Stanley Zhang, a couple of mathematicians at New York University, took a careful look at the Constant Leverage Trap. While they found some situations where the trap failed to trigger, investment returns for leveraged ETFs were usually diminished by it. The market environments that worked out best for leveraged ETFs were those like the past 15 months: a strong upward move in the market together with fairly low day-to-day volatility. In such cases, the new shares the fund purchased each day rarely had to be sold at a loss when the market dropped.
On the other hand, market environments that didn’t work well for leveraged ETFs were sideways markets with higher volatility. When you understand how leveraged ETFs work, this finding makes sense. A sideways market with a lot of volatility would see the market whipping back and forth. The fund managers would get caught again and again in the Constant Liquidity Trap as they rebalanced the fund each day to its leverage target. Without an upward trend, the investor would never get the chance for a sustained win.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.