As Leveraged ETFs Go Berserk, Keep the Biggest Dangers in Mind

My colleague Mike Larson just wrote about the Bitcoin Bonanza, and how the best-performing ETF in our database of more than 2,100 such products is a play on the cryptocurrency. But right below that product were several so-called “leveraged” ETFs, including those targeting home building stocks, South Korean shares, and even volatility index futures.

If you’re not familiar with the concept of leveraged ETFs, they’re designed to enhance the returns you generate from any given investment trend. You can find ETFs that offer 2X leverage, meaning they rise 2% for every 1% move in an underlying index or sector, or those that ramp things up to 3X, meaning they rise 3% for every 1% move. One firm even toyed with the idea of 4X funds back in the spring.

Think the stock market is going to keep going up in a virtual straight line like it has been? Then you might say: “Why not add leverage to my holdings to increase my returns? Why not buy the Direxion Daily S&P500® Bull 3X Shares (SPXL, Rated “B+”) instead of the SPDR® S&P 500 ETF (SPY, Rated “B”), to help me earn more, faster?”

And with the benefit of hindsight, that could have paid off this year. The markets have gone months without a significant correction, and the last pull back we had that extended for multiple days totaled less than 1.5% from peak to trough. Heck, the last time we had a move of more than 10% to the downside in the S&P 500 was in February 2016 — 22 months ago. Since 1954, the market has historically experienced a correction of that magnitude every 18 months.

The problem is that leverage is a double-edged sword! The annual standard deviation of the SPY is 10%, while for the SPXL, it’s 30%. If you slept through statistics class, no worries. That simply means you could lose 30% of your money in SPXL, even in a typical correction, in any given year. It wouldn’t even take an outlying event.

Then there’s the massive pricing problem these ETFs face. Let me give you an example of something that really happened to me – when oil prices fell from $114 to $26 in 2015-2016. The decline was nasty, about 77%. But the plunge in the price of the accompanying triple leveraged ETF was worse. The VelocityShares 3x Long Crude Oil ETN (UWTI, Rated “D-”) fell below a paltry dollar per share.

The sponsor subsequently pushed through a reverse stock split to prop up the per-share price, and the ETF’s ticker symbol was changed to UWTIF. But the end result of the oil price collapse and the use of leverage was simple: If you had bought just one, single share at a split-adjusted price of around $4,000, you’d have just $21 to show for it today!

With ordinary stocks that collapse, you still have a somewhat reasonable chance to recoup your money if the company manages to right the ship. But math gets in the way when it comes to leveraged ETFs.

Consider: I received a phone call from a friend on this fund saying, “Hey did you see the oil ETF fell to $12 bucks from $4,000? It’s gotta be a buy now! It’s probably going to go back to at least $100!”

But his “conservative” math estimates just didn’t add up. In order for the ETF to go from $12 to $100, oil prices would have to soar by 733%! Or in other words, they’d have had to climb to a new price of $216 per barrel. There’s no way the economy could handle that, and therefore no way that target could get hit.

Bottom line: I hated to shatter his optimism. But I’m glad it helped keep him from wasting his money. And the bigger lesson today – not just for leveraged oil ETFs, but ANY such products – is that they’re more complex than your plain-vanilla funds.  You have to factor in slippage, compounding, trading costs, and reset-related issues, not to mention drawdown risks.

So, make sure you do your homework, keep those risks in mind, and stay cautious out there despite the market’s seemingly endless march higher.

Best wishes,

Mandeep