All Articles/On Your Own/Why That Leveraged ETF is a Bad Idea

Why That Leveraged ETF is a Bad Idea

Investors need to understand the risks of the investments they own. Ignoring the risk that leveraged ETFs pose to equity markets is unwise. 

The Dow Jones Industrial Average has had a pretty spectacular run since the Presidential election last November, climbing 8.2%.


(Chart Courtesy of

As we have written many times before in this space, we are neither market timers nor prognosticators of the short-term vicissitudes of the equities market.  Nevertheless, right now may be an opportune time to discuss some of the risks investors currently face.

The change in leadership in the White House presents a number of risks, not the least if which is uncertainty about the specifics of many of the new President’s policy initiatives. Whether or not you support Mr. Trump, it’s undeniable that his unorthodox manner contributes to this uncertainty. And, to be sure, the stock market does not like uncertainty.

Then there is the recent market advance itself, which offers a two-fold complication. The first is fundamental, the second is technical.

While perception has certainly changed since the election, and there is a palpable sense of optimism running rampant on Wall Street, the reality is that as earnings season gets under way this month, little has changed in the way of market fundamentals. Investment-house analysts have not increased earnings expectations for either the fourth quarter of 2016 or the first quarter of 2017. This is because corporate executives have not provided the guidance typically necessary for analysts to make such positive revisions. So, while stock prices have advanced nicely in the last 75 days, the net result is simply that they are trading at higher, perhaps unrealistic, multiples.

Of course, stocks often rise or fall for reasons unrelated to the underlying fundamentals. From a technical perspective, the Dow does seem to be stuck in a narrow trading range, having consolidated the recent gains, and perhaps setting investors up for a bit of a hiccup. Since the beginning of December 2016, the Dow Jones Industrial Average has made several attempts at the 20,000 level, each time running into resistance. At a certain point, this tug-of-war between bulls and bears will end. The sad part is that nobody knows how.

Complicating all of this is the proliferation of leveraged exchange traded funds (ETFs) that are more appropriate for professional traders than they are individual investors. Since 2014 more than 160 leveraged ETFs, with assets totaling more than $23 billion, have been created by various investment management companies.

leveraged2Image source: Adobe Stock

A leveraged ETF is designed to track a multiple of the return of a given index.  For example, the Direxion Daily S&P 500 Bull 3x Shares ETF (NYSE: SPXL) seeks to achieve a daily return of 300% of the daily performance of the S&P 500.  So, if the S&P advances by one point, this fund is designed to rise by 3 points.  The flip side is that if the S&P declines by one point, this fund is expected to drop by those same 3 points.

Here’s the issue.  None of these funds actually owns the stocks or commodities that they are intended to track.  The assets in a leveraged ETF are all private derivatives contracts created specifically for them by an investment bank.

The nature of a leveraged ETF is to borrow a sum considerably higher than the value of the actual financial assets (cash or fixed-income securities) that the fund actually owns.  It is this borrowing that allows a leveraged ETF to achieve returns that are a multiple of the returns of the indexes they track.  This could be a great idea in a market that behaves in a consistent, orderly manner.  Unfortunately, that borrowing means that a dramatic move contrary to a fund’s objective could subject fund owners to lose 100% of their investment.

The more troublesome issue is that many of these ETFs hold the exact same derivatives contracts.  And, most of these contracts are issued by the exact same investment banks.

Just a handful of investment banks act as the counterparties to the several billions of dollars of derivative contracts held by the top six leveraged ETFs.  The vast majority of these derivatives contracts are concentrated at Goldman Sachs, Bank of America, Credit Suisse, and Citibank.

To be sure, each of these counterparties has in some way hedged each of the derivative contracts they hold with each of these funds.  However, the risk is still there – not just to the ETFs, but also to the banks on the other side of those contracts.

As you may well remember from the financial crisis of 2008, unwinding derivatives contracts can be a messy affair.  It can exacerbate a panic and can lead to further market disruption.  So, to ignore the risk that leveraged ETFs pose to equity markets – that arguably are at lofty valuation levels – is in our opinion unwise.  Investors need to understand the risks of the investments they own.  This is especially the case when those investments expose them to the types of risks that borrowing and derivatives bring to the table.

Now, in fairness, it is important to point out that the magnitude of borrowing and use of derivatives throughout the entirety of the leveraged ETF business pales in comparison to the more than $234 trillion of credit default swaps and other investment alchemy that contributed to the global financial crisis a few years ago.  So, we do not believe that leveraged ETFs pose an endemic risk to the worldwide financial system.  Nevertheless, they could very well pose one to the intrepid investor who hasn’t done his or her own due diligence.

The bottom line: It’s unnecessary for an individual investor to use risky products, such as leveraged ETFs. In a retirement portfolio, designed to achieve the very particular goal of generating the return an investor needs for the rest of his or her life, minimizing risk and reducing costs are paramount considerations. High trading fees make these ETFs more expensive than a simple, indexed ETF or passive mutual fund, such as those managed by Dimensional Fund Advisors or Vanguard.

In a nutshell, these leveraged ETFs are less a way of capturing upside and downside market movements, and more of a way to risk your capital unnecessarily.

About the Author

Better Money Decisions