Why not use a leveraged ETF?
One of the questions I get asked frequently is:
Why not just use a leveraged ETF?
Isn’t that going to get the same results as ITM?
Well, no, it isn’t. While it is a common misconception, they work quite differently and get very different results. Let’s see why.
What is a leveraged ETF?
For those of you who are not familiar with leveraged ETFs lets go through what they are and what they do.
We know about SPY which emulates the performance of the S&P 500. There are also ETFs that seek to deliver multiples of the performance. In other words, if SPY goes up 5% then a 2X ETF would go up 10% and a 3X ETF would go up 15%. Some of the biggest are:
- SPUU – Direxion Daily S&P500 Bull 2X Shares (2X SPX)
- SSO – ProShares Ultra S&P500 (2X * SPX)
- SPXL – Direxion Daily S&P500 Bull 3X Shares (3X SPX)
- UPRO – ProShares UltraPro S&P500 (3X SPX)
There are also inverse ETFs, which seek to provide multiples of the opposite return of an index, again either -2X or -3X, for example:
- SDS – ProShares UltraShort S&P500 (-2X)
- SPXU – ProShares UltraPro Short S&P500 (-3X)
At first glance, it looks like leveraged ETFs are similar to ITM, but there is a major difference in results.
How do leveraged ETFs work?
The main thing to note is that these ETFs are NOT designed for long term investing. To achieve their multiplier on one-day returns they are ‘reset’ daily. They use shorting, swaps, futures contract and other derivatives to get their leverage.
People think that the results are easy to understand, but they can get a nasty surprise. A 2X ETF may return 2% on a day when the SPX rises 1%, but you cannot expect it to return 30% in a year when SPX rises 15%. They don’t work that way. Let’s have a look and see why.
EXAMPLE 1
Let’s take a 10 day period where the market is basically flat, going up and down 10% in one day (unlikely, but keeping the math easy). Here is what happens to our leveraged ETFs:
You can see that the market dropped almost 5% over the 10 days – but look at the performance of the leveraged ETFs. They are clearly not tracking the index over time, otherwise their returns would be -10% (instead of 18%) and -15% (instead of 38%).
EXAMPLE 2
Let’s take a more realistic 2% per day move with the up days and down days next to each other.
The actual performance of the ETFs after only 10 days is 4X and 9X, not the 2X and 3X some traders are expecting. Starting to see why there are so many ‘temporary traders’?
Leveraged ETFs are dangerous
Many people recommending leveraged ETFs just don’t understand how they work. They are not suitable for any kind of long-term investing. Because of the daily reset they can very quickly diverge from the index they are trying to track.
The U.S. Securities and Exchange Commission has even put out a warning about them, here’s the link: https://www.sec.gov/investor/pubs/leveragedetfs-alert.htm.
My recommendation? I’m with the SEC. Steer clear of leveraged ETFs. I have seen people get wiped out by them and it’s not pretty.
More Market Pain?
And talking of not pretty, that is how we could describe the market over the last week or so (see the chart above). Right now we are on the 50 day moving average, and so far this year we have bounced off it six times. Will this be the seventh bounce? Or are we in for some more pain?
No-one knows, but we are not at our ITM get-out signal yet.
I am still working on the ITM Bear Strategy book, and still heading for a November publication. Hopefully, we won’t be in a bear market until after then!
Happy Trading
