Leveraged ETFs – Never a Long-Term Investment? (2024)

Leveraged ETFs – Never a Long-Term Investment?

The market crashes every day especially in the last 2 month. If you buy a 3x short ETF on the Nasdaq QQQ, you can make big profits, right? With a 3x leveraged ETF the fund manager does all the work for you, and you can never lose more than you invested. Is that really the case?

If you take away only one thing from this article, it's this: Leveraged ETFs are designed to track the daily performance of their index. They are short term trading instruments. If you hold them for the long term, you are literally leaving returns behind.

For example – the ProShares UltraPro Short QQQ ETF (SQQQ)

The mandate states that: (This is important!) ETF is designed to track the daily performance of the index.

Let’s run an illustration:

Basically, the underlying Nasdaq 100 ETF closes completely unchanged in this sequence of events. And yet SQQQ (-3x QQQ), is down 8.63% below its starting point.

The reason, of course, is that the SQQQ is not designed to track the leveraged returns of the QQQ over a 3 day period. It is designed to track the leveraged returns of the QQQ over a daily period.

Why is that?

To put it in more technical term: The reason you can not create an ETF that tracks the leveraged returns of an index over any period longer than 1 day is because of margin requirements.

If you short the index yourself, and the index goes up, you have to put up more margin (or get a margin call). With an ETF, there is no way for the fund to require more margin from holders of the fund. That is, the fund manager has only the following options:

1. ETF must hold cash
2. ETF must close out all of its positions on a daily basis

Option 1 is too complicated - How much cash do you hold daily, do you hold more cash in times of high volatility, what if you run out of cash etc. Option 1 basically makes you an active fund manager, and the fees are very different for that.

That's why all leveraged ETFs go for option 2. They just track the leveraged daily returns of the index. And at the end of each day, they close their positions, and make sure that no matter what happens the next day, the ETF is able to track the -3x return of the index.

This type of mechanical buying/selling has 2 major side effects - High liquidity at the end of the day and volatility as a driver of volatility.

As you may have noticed, liquidity in the US equity market is always highest at the end of the day. In the last hour to the last 5 minutes of each trading day, trading liquidity is very high. The reason for this is because of the way the mechanical buying of all these ETFs works. At the end of the trading day, many of these ETFs are forced to buy/sell positions mechanically based on how the market has performed that day. They buy/sell based on their mandate, to prepare for the next trading day.

Since everyone in the market knows this, the smart traders save most of their biggest trades for the end of the day, when the big mechanical ETF buys/sells are triggered. This is why liquidity is so high at the end of the day.

Volatility drives volatility - Especially for leveraged ETFs, the more the market moves, the more they have to buy/sell at the end of the day.

• If the NASDAQ moves 1%, the SQQQ needs to buy/sell enough positions to offset a 3% move.
• If the NASDAQ moves 3%, the SQQQ must buy/sell enough positions to offset a 9% move.

Basically, the more the index moves, the more the leveraged ETFs need to buy/sell at the end of the day. This means that sometimes, when liquidity is very tight in the market, these leveraged ETFs will come and dump/buy big positions in the last 5 minutes of trading to further increase volatility.

As should be clear by now, leveraged ETFs are not meant for long-term investing. If you want to enter a short position on the NASDAQ, here are your options:

1. Short the index directly (though you need to keep an eye on risk and margin to avoid margin calls, as bear market rallies are very real and very vicious)
2. Short via option strategies
3. Short selling via CFD (Contract For Difference)
4. Leveraged ETFs seem like a convenient solution, but honestly, if you use them you are actually missing out on returns due to the scenario described above.

Having said all of the above, I still feel more comfortable using an inverse+leveraged ETF.

I do not feel comfortable shorting a stock/index outright, and I do not like the expiration stress of an option (if I choose a long dated option, my premium will be high). If i choose between CFD and an ETF, I'll take the interest accrues at CFD as well as the lower yield of a leveraged ETF.

If I am convinced that there is a long-term downtrend, and I will make a good profit by getting in early, I will hold the securities at a good profit and trade accordingly, watching how the market and macroeconomics develop.