Say you buy a levered ETF that aims to track twice the daily movements in the S&P500 and that you hold it for a few days where the S&P500 is volatile (that is, it goes up and down a lot). For illustration let’s say that the market goes down 20% the first day and then up 25% the next day, to break even (if the index is initially at 100, it would decline to 80 and then add 20, to go back to 100).
Your levered ETF, by design, would go down twice as much as the market on the first day, and up twice as much on the second day. So you’d be down 40% on the first day, and up 50% on the second day. But that would leave you 10% down at the end of the day: If you were initially at 100, you’d decline to 60, and then add 30 to end at 90.
So while the index breaks even, your levered ETF actually declines. It’s even worse for the levered inverse ETFs. In the example above, let’s say you bought the levered inverse ETF that tracks twice the inverse daily changes of the S&P 500. If you start out at 100, you’d be up 40% after the first day and down 50% on the second day. So you’d be at 140 after the first day, and cut in half to 70 after the second day. In sum, you’d be down 30% from where you started.
The levered ETFs work this way because of compounding effects. And as you can see, in volatile markets they have a tendency to decline. Over time, they tend to go towards zero. Many investors have realized this in practice. They buy a levered ETF to “up the ante” only to get knocked down by volatility.
These products tend to work only for short term trades where you get the direction right! Unless you have superior market timing skills you should be very careful in using these products. If you want exposure to the markets, in most cases you’d be better off buying a regular ETF when the price is right and hold it for the long term. Investing Course
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