Key insights
- The article discusses the risks associated with leveraged ETFs, particularly volatility decay. It highlights that these funds use derivatives to achieve a multiple of the underlying index's *daily* return, which can lead to unexpected results and losses, especially in choppy markets. Investors should understand the mechanics and risks before using these products.
In markets where the S&P 500 is seemingly returning double digits every year, a lot of investors feel emboldened to try to amplify those returns even further.
Funds such as the ProShares UltraPro QQQ ETF (TQQQ 1.35%), which targets 3x the Nasdaq-100's daily performance, have been around for a long time. But the ETF industry has taken it to another level over the past couple of years. According to the ETF Action database, there are more than 430 leveraged funds available to investors. Over 270 of them are based on a single stock, and roughly two-thirds opened in the past year.
Leverage may be all the rage on Wall Street, but that doesn't necessarily make it a good idea. Use these funds in ways they're not intended, and the results could be disastrous.
Leveraged ETFs tied to stocks or equity indexes don't actually invest in stocks at all. They invest in derivative contracts that deliver a multiple of the underlying security's daily return. The "daily" part is important to highlight.
The ProShares UltraPro QQQ ETF, for example, is built to deliver triple the daily return of the Nasdaq-100. After the trading day ends, leverage is reset, and the cycle repeats the next day. If you hold a leveraged ETF beyond a single day, your returns could vary relative to the underlying index.
Unfortunately, the daily reset creates a mathematical drag called volatility decay. When an index fluctuates significantly without a clear trend, the compounding effect can work against the owner. If a leveraged fund falls by 10% and then rises by 10% on back-to-back days, it doesn't break even. If choppy trading persists for a long enough period, it can cause a leveraged product to lose money even as the underlying asset rises in value.