One-Night Stands and Leveraged ETFs
One-nights stands, in my opinion, are perfectly fine if both parties understand what it is and nobody is misleading anyone. Much the same, investing in leveraged ETFs can be exciting as long as you understand exactly what to expect and know going in it’s not for the long-term. Otherwise, if you wake up holding onto a leveraged ETF the next morning, you might feel an undeniable sense of regret wash over you.
Leveraged ETFs, like the 3x daily bull and bear ETF lineup from Direxion Investments, are designed to give investors more juice than traditional investment vehicles. They are built to provide three times the daily return of an underlying index in the case of the 3x bull variety, or three times the inverse in the case of the 3x bear.
Sounds great, right? Why settle for a 10% return when you can have 30%? Well in a single trading day they are fairly effective at delivering that 3x multiple, but it’s not so simple over the long-term. The problem is the return of these leveraged ETFs is path dependent, meaning the underlying index’s return alone does not determine the return for the ETF — the path the index took to get there is also a factor.
Below is an example that shows a hypothetical underlying index that is up 4% for the week as well as the returns of a hypothetical 3x bull ETF (ignoring fees and trading costs) under five different paths to that 4% return.
One would assume if the index was up 4% for the week the 3x bull should be up 12%, but this isn’t necessarily the case. The first path shows us a perfect even and upward path, and in this scenario the leverage enhances the benefits of compounding and the return is actually higher than 12%. The second path shows an example where the price only moves one day and is flat all other days, and in this case the leveraged ETF return is the same as three times that of the index. The next two paths include down days and have increasingly higher standard deviations (a measurement of the variability of returns). You’ll notice as the volatility increases, the return for the leveraged ETF decreases. Lastly, path #5 is an extreme example that includes both the worst single trading day loss in the history of the S&P 500 (October 19, 1987) as well as the best up day in the index’s history (October 13, 2008). This example shows a very large negative return for the 3x bull and highlights the damage extreme swings can have on leveraged ETFs.
This is not to say a 3x bull ETF won’t give you great returns in a prolonged and steady bull market — it certainly will. For example, in 2013 we saw a steadily increasing equity market and the S&P 500 finished the year up 32.39%. The Direxion Daily S&P 500 Bull 3X ETF (ticker:SPXL) was up a staggering 118.37% that year, 3.65 times more than the market. You just need to be aware that they are not perfect. In 2012 — a volatile but ultimately flat year — the S&P 500 returned only 2.11%; basically the equivalent of its dividend. SPXL, on the other hand, lost 14.91%.
Leveraged ETFs do very poorly in volatile, sideways markets like 2012, and they typically capture slightly less than three times of an up market and slightly more than three times of a down market (a bad thing). This mathematical phenomenon, known as leveraged decay, gradually erodes the actual return of leveraged ETFs from what would be intuitively expected.
The allure of big returns can be tempting, but these investments are not appropriate for most buy-and-hold investors. Even for experienced traders looking for a little excitement, when it comes to a leveraged ETF it’s best to just get in and get out quickly.