Key Points
Even when the market fully recovers from a downturn, a leveraged ETF often doesn't.
The S&P 500 returned to its late-2021 levels by the end of 2023, but the leveraged ProShares Ultra S&P 500 fund was still 11.7% underwater.
These ETFs are designed for short-term trading, not long-term investing.
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Imagine you're at a casino, and someone offers you a deal: every time the roulette wheel lands on black, you win double. Sounds amazing, right? But there's a catch. Every time the ball lands on red, you lose double too.
That's basically a leveraged exchange-traded fund (ETF) in a nutshell.
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The math problem nobody warns you about
Leveraged ETFs tend to be volatile assets, and their prices reset daily. This cycle creates a mathematical effect called "volatility decay," which sounds boring but is actually a silent killer of your returns.
Here's a simple example:
- Day 1: The S&P 500 (SNPINDEX: ^GSPC) drops 10%. Your 2x leveraged ETF, perhaps the ProShares Ultra S&P 500 (NYSEMKT: SSO), drops 20%. Ouch, but OK.
- Day 2: The S&P 500 gains 11.1% (back to even). Your 2x ETF gains 22.2%. Sweet!
Image source: Getty Images.
You'd think you're back to even too, right? Nope. Your 2x ETF is still down about 2.2%. The market recovered; you didn't. Now multiply that by months and years of normal market zigzags.
For example, the S&P 500 fell 19.5% in the inflation-stricken year of 2022, while the ProShares Ultra fund dropped 39.3%. The market posted a 46.4% return the following year, landing almost exactly where it was two years earlier. The leveraged fund only saw a 24.3% recovery, leaving a big gap to the prices seen at the end of 2021:
The good years aren't good enough
In a smooth bull run, leveraged ETFs look like genius plays. But markets don't move in straight lines. They hiccup, correct, panic over tweets, and occasionally have full-blown tantrums. Every uncomfortable wiggle chips away at your leveraged position.
Leveraged ETFs are designed for day traders and short-term tactical moves. Think hours or days, not years. The fund companies literally tell you this in the fine print. They're specialized trader tools, not solid long-term investments.
Boring old index funds may not make you feel like a Wall Street genius, but they also won't make you cry into your coffee after a choppy quarter.
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Anders Bylund has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
