Avoid The ETF Leverage Trap

I got a refreshing reminder of that talking to someone who had lost a lot by buying and holding a leveraged ETF.

The crux of the issue is the "constant leverage trap"-a term that applies to funds that reset their leverage daily. In short, the constant leverage trap means that in trendless, volatile markets, leveraged ETFs lose far more of their value than you'd expect intuitively.

Explanations of the constant leverage trap abound on the Web, and they're worth a review if you're considering-or already invested in-leveraged ETFs. (See this IndexUniverse webinar and an article by New York University's Marco Avellaneda and Jian Zhang published a year ago in "Risk Professional.")

Even after a reminder of how the returns on these funds erode in volatile markets, there are a couple of points worth hammering home.

Firstly, the constant leverage trap applies to inverse (-1X) ETFs too. I once assumed only leverage factors greater than 1 resulted in the unexpected decay of returns. That's wrong. The daily reset on single-exposure inverse funds results in exactly the same effects, albeit muted compared with larger leverage factors. It helps to see a concrete example.

Twelve-month returns of the Direxion Daily Small Cap Bear 3X (in blue) and Direxion Daily Small Cap Bull 3X (in red).

Don't forget to check IndexUniverse.com's ETF Data section.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.