Why 3x ETFs Are Riskier Than You Think (2024)

FAQs

Why 3X ETFs are riskier than you might think? ›

The idea behind 3x ETFs is to take advantage of quick day-to-day movements in financial markets. In the long term, new risks arise. Because of how leveraged ETFs are constructed, they are only intended for very short holding periods, such as intraday.

The inherent structural problem with leveraged ETFs, especially the triple leveraged ETFs, is they're only designed to be held short-term as they only mirror the single-day performance of the underlying asset. To maintain a consistent leverage ratio (2X or 3X), they're rebalanced nightly.

Market risk

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.

Leveraged ETFs decay due to the compounding effect of daily returns, also known as "volatility drag." This means that the returns of the ETFs may not match the returns of the underlying asset over longer periods.

Whether or not leveraged ETFs are a systemic risk to markets, they are extremely risky to buy and hold. Many investors may not see this, considering TQQQ has only gone up over the long-run. However, when a larger crash occurs, the fund may find itself seeing 95%+ losses.

A disadvantage of leveraged ETFs is that the portfolio is continually rebalanced, which comes with added costs. Experienced investors who are comfortable managing their portfolios are better served by controlling their index exposure and leverage ratio directly, rather than through leveraged ETFs.

Cons of Leveraged ETFs

Amplified market risk: Since leveraged ETFs are designed to amplify the returns of a benchmark index, the downside risk is equally amplified. For example, a 2x leveraged ETF may double the daily return of a benchmark index, but it may also double the decline.

The hope is that the return on the investment (ROI) will be greater than the cost of borrowing. Leverage can magnify returns but can also magnify losses, and is therefore considered a risky investment strategy that should only be used by professionals.

In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges. Their value can fluctuate throughout the day in response to market conditions. This means that if the market takes a dip, the value of your ETF could drop quickly, and you could experience significant losses.

Are ETFs riskier than funds? ›

While it is true that investors take on added risk if they do not fully understand the nature of their investments or the typical price action that accompanies them, ETFs do not typically offer a greater degree of risk than similar index-based funds. There is nothing inherently risky with ETFs in general.

A trader can hold the majority of these ETFs including TQQQ, FAS, TNA, SPXL, ERX, SOXL, TECL, USLV, EDC, and YINN for 150-250 days before suffering a 5% underperformance although a few, like NUGT, JNUG, UGAZ, UWT, and LABU are more volatile and suffer a 5% underperformance in less than 130 days and, in the case of JNUG ...

Yes, although most would liquidate before they got there, paying shareholders off at some non-zero price. For example, suppose a 3x levered ETF is initially offered at $100/share. Even if the underlying declined by more than 33%, the ETF price would not be zero, because it rebalances daily.

The daily resetting of leveraged ETFs means the fund only provides the return multiple relative to the underlying index on a daily basis, not necessarily over the long term. Because of this, volatility of the index can eat away at gains; this is known as volatility decay or beta slippage.

Less Diversification

For some sectors or foreign stocks, investors might be limited to large-cap stocks due to a narrow group of equities in the market index. A lack of exposure to mid- and small-cap companies could leave potential growth opportunities out of the reach of ETF investors.

Wider Variety. The chief advantage of mutual funds that cannot be found in ETFs is variety. There is a virtually unlimited number of mutual funds available for all different types of investment strategies, risk tolerance levels and asset types.

Commissions and management fees are relatively low and ETFs may be included in most tax-deferred retirement accounts. On the negative side of the ledger are ETFs which trade frequently, incurring commissions and fees; limited diversification in some ETFs; and, ETFs tied to unknown and or untested indexes.

Market risk: Leverage funds like TQQQ can see extreme swings in prices, which makes this ETF too risky for investors who have a low tolerance for volatility.

This fund is not suitable for a long-term hold; investors who buy-and-hold SQQQ find their returns badly damaged by expenses and decay. Several key factors prevent SQQQ from serving as an acceptable core holding in an investor's portfolio. The first is the short-term focus of the fund; it is not a buy-and-hold ETF.

Should I buy QQQ or TQQQ? ›

However, because of the structure of leveraged ETFs, the recommended holding period is from intraday to only a few days. Moreover, if the index drops, the TQQQ will lose 3x as much as the QQQ. Therefore, TQQQ may be better suited for day traders or swing traders.

Because leveraged single-stock ETFs in particular amplify the effect of price movements of the underlying individual stocks, investors holding these funds will experience even greater volatility and risk than investors who hold the underlying stock itself.

The biggest risk that arises from high financial leverage occurs when a company's return on ROA does not exceed the interest on the loan, which greatly diminishes a company's return on equity and profitability.

The most significant disadvantage of leverage is that there is a risk that a company will use too much leverage, which can lead to problems for the company because there will be no benefit to taking leverage beyond an optimum level of leverage.

Are Concerns About Leveraged ETFs Overblown? Leveraged and inverse exchange-traded funds (ETFs) have been heavily criticized for exacerbating volatility in financial markets because it is thought that they mechanically rebalance their portfolios in the same direction as contemporaneous returns.

Beginning January 22, Vanguard will no longer accept purchases in leveraged or inverse mutual funds, ETFs (exchange-traded funds), or ETNs (exchange-traded notes). We're making this change because these products and services do not align with our investors' focus on the long term.

The purpose of leveraged ETFs is to amplify the daily returns of an index instead of simply matching the index's performance. This is an important distinction between a traditional ETF and a leveraged ETF. A leveraged ETF resets each day, which compounds the fund's gains and losses.

Since ETFs are more diversified, they tend to have a lower risk level than stocks. Similar to stocks, ETFs can be bought and traded at any time and they are also taxed at short-term or long-term capital gains rates.

The Morningstar risk rating is a ranking given by research firm Morningstar to publicly traded mutual funds and exchange traded funds (ETFs). A score of 5 is given to the best risk performers, with a 1 to the worst. Morningstar ratings are based on the fund's historical performance compared to other like funds.

You're forced to sell or take liquidation proceeds, which can create a tax burden or lock in investment losses. You may incur a capital gains tax on profits if the ETF's in a taxable account, that is, a non-retirement account. If you owned the fund less than a year, the profit will be taxed at your normal tax rate.

What type of ETF is safest? ›

1. Vanguard S&P 500 ETF (VOO 0.85%)

Investors looking to weather a recession can use exchange-traded funds (ETFs) as one way to reduce risk through diversification. ETFs that specialize in consumer staples and non-cyclicals outperformed the broader market during the Great Recession and are likely to persevere in future downturns.

Even if there is some decline in trading volumes on the US stock exchanges, ETFs are not the cause of it. Bank regulation is the main reason for reduced liquidity. In the past, banks held large volumes of stocks and bonds in their own books.

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often. However, ETFs also have a structural ability, called the in-kind creation/redemption mechanism, to minimize the capital gains they distribute.

Exchange-Traded Funds (ETFs), which track indices such as Nifty and Sensex, may witness higher volatility than the underlying assets of the ETF. The poor liquidity position of the ETFs on the exchange may result in mispricing of the ETFs on the exchange compared to its underlying assets and may cause higher volatility.

While stocks are just one instrument, an ETF is a basket of securities consisting of diversified investments such as stocks, commodities, bonds, and other securities. These funds are called holdings. The shares to these holdings are then sold to investors by the fund manager.

From an investor's point of view, this means you can hold fewer of them to get a wide-ranging portfolio. But can you really get enough diversification with just three ETFs? Yes. In fact, some experts say you could even have a well-diversified portfolio with just two products.

Leveraged 3X Inverse/Short ETFs seek to provide three times the opposite return of an index for a single day. These funds can be invested in stocks, various market sectors, bonds or futures contracts. This creates an effect similar to shorting the asset class.

On the other hand, having too many ETFs can lead to over-diversification and excessive fees, as well as potential underperformance if the ETFs are not chosen carefully.

Direxion launched its first leveraged ETFs in 2008. In November 2008 the company was the first to offer ETFs with 3X leverage, a move that was copied some months later by its competitors ProShares and Rydex Investments.

What is the best 3X ETF? ›

Direxion Daily Tech Bull 3x ETF (TECL)

The fund's objective is to achieve three times the daily return of the Technology Select Sector Index. TECL is one of the most popular tech-oriented leveraged ETFs, with an AUM of $1.7 billion. Its average trading volume makes it a very liquid option for rapidly evolving markets.

TQQQ can underperform QQQ even if QQQ rises in the long run. This happens in volatile markets where volatility decay eats away at TQQQ returns. While most TQQQ investors primarily fear a bear market, volatility decay during bull markets accounts for a significant portion of TQQQ underperformance.

Back tests show that TQQQ can be held longer term (1-Year) and beats QQQ but holding for too long (5 Years) can significantly worsen performance. Holding TQQQ for too long almost guarantees that you will encounter a protracted bear market that wipes out nearly your entire portfolio.

Thinking of getting options or shares on TQQQ but then realized if the Nasdaq drops by 33.3% or more in a day, tqqq will drop to zero.

On the other hand, the TQQQ ETF seeks to track the Nasdaq-100 index and provide 3X the return before fees and expenses. So, if the Nasdaq-100 rises by 1%, the TQQQ ETF should rise by 3%. It should be noted that the SQQQ and TQQQ ETFs are prone to time decay because they are made up of financial derivatives.

Cons. Higher expense ratio – Comparatively leveraged ETFs require more management; due to this reason, these ETFs have a higher expense ratio than traditional ETFs. So, these ETFs could cost you more as they are associated with trading in financial derivatives.

ETFs are very safe and are an excellent option for long-term investments. According to experts, ETFs are not that volatile and show a slight change in their prices compared to stocks and indices because they are diversified and pooled investments of many investors.

As with the first example above, a triple-leveraged S&P 500 ETF loses 60% when the underlying index only loses 20%. In some rare cases, particularly when derivatives are used, a leveraged ETF can even lose all or most of its value.

This fund is not suitable for a long-term hold; investors who buy-and-hold SQQQ find their returns badly damaged by expenses and decay. Several key factors prevent SQQQ from serving as an acceptable core holding in an investor's portfolio. The first is the short-term focus of the fund; it is not a buy-and-hold ETF.

No, you cannot lose more money than you invested in a leveraged ETF. This is one of the main reasons why leveraged ETFs are considered less risky than traditional leveraged trading, such as buying on margin or short-selling stocks.

Do hedge funds use leveraged ETFs? ›

The second way hedge funds use leveraged ETFs is to capitalise on the daily price movements of a market, index or specific sector. However, to avoid adverse compounding effects, most will buy and sell their shares in a leveraged ETF during the same trading day.

Leveraged ETFs utilize forms of leverage, such as debt, futures, options, and other financial instruments in an effort to yield these higher returns. This makes leveraged ETFs both deeply lucrative and incredibly risky; potential gains are multiplied, but potential losses are, too.