Investment Considerations for Leveraged ETFs: High Risk, High Reward or Regret?
Investing in leveraged ETFs (Exchange-Traded Funds) can be a double-edged sword, offering the potential for significant returns but also posing substantial risks. Contrary to what some might believe, these products are not suitable for long-term investment strategies. This article delves into the risks and rewards of leveraged ETFs, supported by historical performance data, to help investors make informed decisions.
Understanding Leveraged ETFs
Leveraged ETFs are financial products designed to provide investment returns that are theoretically two or three times (2x, 3x) the daily performance of the underlying index. While they can be appealing for short-term trading and speculative strategies, they are not recommended for long-term investment plans due to their volatility and the compounding effects of fees and losses.
Risk and Reward Analysis
The following table provides a comparison between investing in the SP 500 Index (1x) and its leveraged counterparts (2x and 3x versions) from 1950 to the present. The analysis focuses on outcomes for 10-year investments, with returns adjusted for risk-free rates and inflation. Fees are accounted for, and taxes and commissions are ignored for simplicity.
InvestmentLosses (Over 50%)Average Loss (%)Excess Returns (10-year period)Median Excess Returns (10-year period)Years with Losses Over 25% SP500 (1x)354313018 2x Levered SP500 ETF2571501235 3x Levered SP500 ETF358079-2655Why Leveraged ETFs Are Not Suitable for Long-Term Investments
While the levered products can offer higher average returns, they do so at the cost of extreme volatility. The 2x and 3x levered ETFs have a significantly higher probability of losing more than 50%, and their average losses can be as high as 71% and 80%, respectively. In contrast, the SP500 index loses more than 50% only 3 out of 10 times, with an average loss of 54%.
The median 10-year excess returns for the 2x and 3x levered ETFs are 12% and -26%, respectively. This means that half the time, the 3x levered SP500 ETF loses more than 25% compared to the risk-free rate over a 10-year period. For long-term investors, these high loss probabilities and average returns make leveraged ETFs more akin to lottery tickets than reliable investment vehicles.
More Efficient Investment Strategies
Instead of using leveraged ETFs, it is more efficient to allocate more money into the underlying index. For example, a 100 dollar investment in the 2x SP500 ETF would yield returns similar to a 225 dollar investment in the SP 500 Index, with an additional 20 dollar profit. The 3x levered ETF, which is equivalent to a 392 dollar investment in the SP 500 Index, would yield the same 10-year returns with an additional 42 dollar profit, but at the cost of significantly increased volatility.
Investors should consider alternative investment strategies that offer higher returns with lower volatility, such as broader diversification, value investing, or tactical asset allocation. These strategies not only mitigate the risks associated with leveraged ETFs but also provide the potential for more stable and sustainable long-term growth.
Conclusion
Leveraged ETFs may offer the allure of high returns, but they come with significant risks, particularly for long-term investments. For most investors, it is far more prudent to allocate more capital to the underlying index and avoid the pitfalls associated with leveraged ETFs. By understanding the unique risks and rewards of these products, investors can make more informed decisions and build a more resilient investment portfolio.