Leveraged ETF

A Leveraged ETF is a type of Exchange-Traded Fund (ETF) that uses financial debt and derivatives to amplify the daily returns of an underlying benchmark index. Think of it as an ETF on steroids. These funds aim to deliver a multiple—typically 2x or 3x—of the daily performance of the index they track. For instance, if the S&P 500 goes up by 1% on a given day, a 2x leveraged S&P 500 ETF aims to go up by 2%. Conversely, if the index drops by 1%, the ETF is designed to fall by 2%. While this sounds enticing, it’s a double-edged sword that cuts deeply on the way down. Crucially, this leverage is reset daily, a feature that introduces complex risks and makes these products unsuitable for most investors. They are high-cost, speculative tools designed for sophisticated traders making very short-term bets, not for building long-term wealth.

To achieve this amplified return, the fund manager doesn't just buy more stocks. Instead, they employ a cocktail of complex financial instruments. This includes borrowing money to buy more of the underlying assets, but more commonly, it involves using derivatives such as futures contracts, options, and swaps. These instruments allow the fund to gain leveraged exposure to the index without owning all the underlying securities directly. The key mechanism to understand is daily rebalancing. At the end of each trading day, the fund manager adjusts the fund's positions to ensure the leverage target (e.g., 2x) is correct for the start of the next day. This constant shuffling is what causes the long-term performance to diverge wildly from what an investor might expect.

Leveraged ETFs are littered with traps for the unwary investor. Their structure almost guarantees poor long-term results, especially in volatile markets.

This is the number one reason why holding a leveraged ETF for more than a day is a bad idea. The daily rebalancing creates a corrosive effect on returns over time, a phenomenon known as beta slippage or compounding decay. Let's look at a simple example: Imagine an index starts at 100 points, and you buy a 2x leveraged ETF tracking it.

1. Day 1: The index rises 10% to 110. Your 2x ETF performs as expected, rising 20% to 120. You're thrilled.
2. Day 2: The market gets choppy. The index falls 9.1% from 110, returning it right back to 100.

Now, what happens to your ETF? It will fall by double the index's percentage drop: 2 x 9.1% = 18.2%. Your investment, which was at 120, now falls by 18.2%, leaving you with just 98.16. Over two days, the underlying index is perfectly flat, but your leveraged ETF has lost nearly 2% of its value. In a sideways or volatile market, this decay eats away at your capital relentlessly, making it a terrible instrument for a buy-and-hold strategy.

Managing a portfolio of complex derivatives and rebalancing it daily is expensive. Consequently, leveraged ETFs carry a much higher expense ratio than plain-vanilla index ETFs. These high fees act as a constant drag on performance, further compounding the negative effects of beta slippage and ensuring that the house (the fund provider) always has a significant edge.

Let’s be crystal clear: leveraged ETFs are the polar opposite of value investing. They are instruments of pure speculation, not investment. The philosophy of value investing, championed by figures like Benjamin Graham and Warren Buffett, is built on foundational principles that leveraged ETFs violate at every turn.

• Long-Term Horizon: Value investing is about owning a piece of a wonderful business for a long time. Leveraged ETFs are designed for day traders.
• Intrinsic Value: A value investor carefully analyzes a business to determine its intrinsic value. The price of a leveraged ETF has almost no connection to the underlying value of the companies in the index; it's a mathematical derivative of daily price volatility.
• Margin of Safety: The core of value investing is the margin of safety—buying an asset for significantly less than its intrinsic worth to protect against unforeseen problems and errors in judgment. Leveraged ETFs offer a margin of danger, amplifying risk and exposing investors to catastrophic losses.

As Benjamin Graham famously wrote, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Leveraged ETFs fall squarely and deeply into the speculative camp. For ordinary investors, they are best avoided entirely. They are a solution in search of a problem you don't have.