Leveraged exchange-traded funds, or ETFs, can effectively double or triple your exposure to a certain index or asset class and can be used to create a long (bull) or short (bear) position. For example, a triple-leveraged S&P 500 ETF will return three times the daily performance of that index. However, before you buy a triple-leveraged ETF, it's important to know how they work -- and the drawbacks of holding them for long periods of time.
Three examples of triple-leveraged ETFs
Continue Reading Below
To illustrate what these investment vehicles are and what they might be used for, here are three examples of popular triple-leveraged ETFs. To be clear, I'm not recommending or endorsing any of these.
- The Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS) tracks the Russell 1000 Financial Services Index, whose top holdings include Berkshire Hathaway, JPMorgan Chase, and Wells Fargo. The fund uses instruments that seek to produce 300% of the index's daily performance.
- The ProShares UltraPro Short S&P 500 ETF (NYSEMKT: SPXU) is an inverse triple-leveraged ETF that aims to return three times the inverse of the S&P 500's daily performance. In other words, if the S&P 500 decreases by 1% today, this fund should theoretically gain 3%.
- The Direxion Daily Gold Miners Index Bull 3X Shares (NYSEMKT: NUGT) amplifies the daily performance of the NYSE Arca Gold Miners Index, which includes companies that primarily mine for gold.
The problem with holding triple-leveraged ETFs in your portfolio
Leveraged ETFs tend to have above-average expense ratios (fees), and that is certainly the case with the ETFs I mentioned above, although I wouldn't necessarily call the fees excessive. Besides, the fees aren't the reason most investors should avoid leveraged ETFs.
Here's the problem. Notice the key word "daily" that appears in all three fund descriptions. Triple-leveraged ETFs typically produce triple the daily return of the underlying index/investment. You might think that this would produce triple the return of the index over long periods of time, but mathematically, this is simply not the case.
Consider this simplified example. Let's say that a certain stock index that starts at $100 falls by 20% on the first day (now $80), rallies by 20% on the second day (now $96), and then falls by 25% on the third day (now $72). Overall, this produces a net loss of 28% for the three-day period.
A triple-leveraged ETF tracking the same index would fall by 60% on the first day (now $40), rise by 60% on the second day (now $64), and drop by 75% on the third day (now $16). This translates to a three-day loss of 84%, which is exactly three times the loss of the index. No big surprise yet.
The problem is what these loss percentages mean. In the first case, the non-leveraged ETF would have to rise by 39% to get you back to even. On the other hand, the leveraged ETF would have to rally by a staggering 525% just to break even.
Again, this is a simplified example, but mathematically, the point is that declines in the index have a more devastating effect on the long-term performance of leveraged ETFs, essentially creating a negative bias over time (unless the index goes straight up forever). In other words, these funds rarely, if ever, match triple their index's performance over long time periods.
Take a look at the performance stats in the table. As an example, the triple-leveraged financial sector ETF averaged a 45.9% annualized total return over the past five years, which sounds excellent at first. One-third of this would be 15.3%. However, the financial sector has generated total annualized returns of 17.5%, on average, over the same time period. So if the leveraged ETF had returned triple the index's return each year, the annualized return should have been a much greater 52.5%.
On the other hand, consider the example of the triple-short S&P 500 ETF. If you had simply shorted the S&P 500 over the past five years, you would have lost 54.6% of your investment. So a $10,000 investment would have turned into $4,540. Not great performance by any definition. However, if you had purchased the triple-leveraged short S&P 500 ETF, you would be down 92.1%. Your $10,000 investment would now be worth just $790.
The takeaway is this: If the underlying index moves favorably, triple-leveraged funds can certainly go up, but they tend not to actually produce three times the underlying index's performance. On the other hand, when the underlying index isn't moving in your favor, triple-leveraged ETFs can be absolutely dangerous.
The Foolish bottom line
To be perfectly clear, leveraged ETFs like those I discussed here certainly serve a purpose. For example, professional traders can use them as a hedge against big market moves.
Rather, I'm saying that these make lousy long-term investments and should therefore be avoided by investors who have a long-term focus. In other words, if you want to bet on the S&P 500, buy a standard S&P 500 index fund like the Vanguard S&P 500 ETF (NYSEMKT: VOO). Leave the leveraged ETF versions of this investment alone.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.