Since leveraged ETFs are specially created financial products designed for speculators, individuals who buy or trade them without understanding how they work should be extra cautious, because many leveraged ETFs are not structured like ordinary ETFs.
The Difference Between Leveraged and Regular ETFs
From time to time, the net asset value (the value of the underlying securities) may deviate from the market price, but on the whole, the performance should track the underlying index and equal that performance over long periods (minus the expense ratio). Simple enough. With a leveraged ETF, however, the fund uses debt and derivatives to amplify the returns of the underlying index at a ratio of 2-to-1 or even 3-to-1, instead of 1-to-1 like a regular ETF. The financial derivatives and debt used in these funds introduce an outsized amount of risk, even as they have the potential to produce outsized gains. Leveraged ETFs also often come with higher expense ratios than regular ETFs.
What Happens When You Buy and Hold an ETF Like TQQQ
With a leveraged ETF, on top of the asset management fees, frictional expenses such as trading costs, and custody fees, you have the interest expense of the debt used to achieve the actual leverage. That means that every moment of every day, interest expense or its effective equivalent is reducing the value of the portfolio. Let’s take a look at one such ETF, the ProShares UltraPro QQQ (Nasdaq: TQQQ), which leverages the Nasdaq-100 3-to-1. If the Nasdaq-100 moves by 1%, TQQQ moves by 3%. If the market goes sideways, the ETF’s shares will lose money, a reality that is exacerbated by the fact that the portfolio rebalances daily. Due to compounding, leveraged ETFs held over the long term can see strikingly different returns than the fund’s target. Because these funds reset each day, you can see significant losses—even if the fund itself appears to be showing a gain.
Who Should Consider Leveraged ETFs?
Who are these leveraged ETFs designed for, then? What types of people or institutions should consider buying or selling them? The answer is clear when you understand that they aren’t meant for long-term investment at all. Investing involves owning shares of companies and collecting dividends, or lending money and collecting interest income, and it is necessary for the functioning of the economy. Investors often follow long-term strategies and have future goals in mind when buying stocks, ETFs, or other investments. The purpose of leveraging a stock market benchmark (such as the Nasdaq-100) by 300% and then resetting it every day is a way to gamble without risking the dangers of directly employing margin debt. You can take the long side (bet that it will increase) or the short side (bet that it will decrease) as both have their own respective ticker symbols.
Understanding the Risks for New Investors
The takeaway of all of this for new investors is simple: Don’t invest in something you don’t understand. If financial derivatives, options contracts, and futures—all of which are tools used in leveraged ETFs—are beyond your comfort zone, stick to other investments.
