LEVERAGED ETFS - by Karim Ghaidan

LEVERAGED ETFs

As our readers are well aware we are maximally bearish in the medium to long term on risk assets. We are so bearish that we even occasionally dream about the amount of money we could make by indulging in buying an inverse 2x or even 3x leveraged ETF to add on top of the leverage we already get by trading CFD’s.
 
We will never do so and this article explains why.
 
We use the S&P500 as our proxy for risk, however the principle of this macro piece can be applied to any index and in this case we will use the NASDAQ as it is far more volatile and currently experiences mass investor long involvement.
 
What is a leveraged ETF?
A leveraged ETF is designed to return a multiple of the daily return of an index. The keyword here is "daily". Here is a simple numerical example:
 
NASDAQ is at 4000. QLD is a 2x leveraged ETF designed to yield 2X the daily return of NASDAQ and is currently trading around the $100 mark:
Day 0 - NASDAQ 4000, QLD 100.00
Day 1 - NASDAQ 4120 (up 3%), QLD 106 (up 6%)
Day 2 - NASDAQ 3996.4 (down 3%), QLD 99.64 (down 6%)
Day 3 - NASDAQ 4116.3 (up 3%), QLD 105.62 (up 6%)
Day 4 - NASDAQ 3951.6 (down 4%), QLD 97.17 (down 8%)
Day 5 - NASDAQ 4003 (up 1.3%), QLD 99.69 (up 2.6%)
 
In this example, the NASDAQ barely moved, ending the week up 0.075%. However, QLD ends the week DOWN $0.31. No, it is not due to a rounding error. You can check it yourself.
 
So what happened?
The problem is compounding. A leveraged ETF guaranteeing a multiple of a daily return does not guarantee a multiple of the return over a year, month, week, or even two day period.
 
And the larger the index moves, the bigger the problem:
Day 0 - NASDAQ 4000, QLD 100
Day 1 - NASDAQ 3600 (down 10%), QLD 80 (down 20%)
Day 2 - NASDAQ 3960 (up 10%), QLD 96 (up 20%)
Here, the NASDAQ is down 1% over 2 days, but QLD is down 4%.
 
Or even more volatility:
Day 0 - NASDAQ 4000, QLD 100
Day 1 - NASDAQ 2000 (down 50%), QLD 0 (down 100%)
Day 2 - NASDAQ 4000 (up 100%), QLD 0 (up 200%)
 
This is the reason we have chosen the NASDAQ as the index to portray this principle. It may be difficult to imagine the S&P500 loosing 50% of its value in one trading session, however those who were long the NASDAQ at the height of the last dotcom boom can easily remember the huge moves it experienced on a daily basis.
What this example shows you is how exposed you are to volatility when investing in leveraged ETFs. The NASDAQ ends the two day period unchanged but you just lost all your money.
 
All these "UltraShorts" and "Bull 3X's" may sound like they are giving you a multiple of an index's return, but these returns are daily and not long term.
The longer the timeframe, the more volatile the underlying product and the bigger the multiple the bigger the compounding problem gets (3X is worse than 2X is worse than 1.5X).
 
Conclusion
Not only are your medium to long term returns not guaranteed to match the index, leveraged ETF’s expose you to unneeded market volatility. Unsurprisingly, one of the worst periods for ETFs was late 2008, when the markets were hugely volatile with regular 3-5% daily swings. All leveraged ETFs suffered during this period due to compounding.
 
For those trading CFD’s who wish also to trade leveraged ETFs as a CFD the hazards are compounded astronomically as leverage is heaped upon leverage.
 
Leveraged ETFs are not for the investor or trader whose time horizon is longer than the end of the day. They may be great for quant shops, hedge funds, and day traders, but they are poison for everyone else.
 
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