I often end up talking about finance a lot, and in doing so often mention investing strategies and asset classes that many regular retail investors aren’t aware of. Although the world of financial derivatives is vast and unknown to most, I wanted to make a brief post about some simple products which I think should have more publicity, primarily that of leveraged ETFs. This post is a brief introduction to some investing strategies that some retail investors choose to use for higher risk tolerance and significantly greater potential performance. This post is not investment advice, in case I need to actually say that. I should also add that suggesting holding leveraged ETFs for longer periods is a relatively controversial view within the wonderful world of dollarmancy; nonetheless I present my own views here honestly should anyone wish to know them.

Cash is not your friend

At the lowest level of risk tolerance, many choose to simply keep their savings in cash. This is bad when done for longer periods. It is often pointed out that you will slowly lose money to inflation over time (whether that is the 2% inflation rate that the FOMC targets per year, the ~7% rate of 2021, or perhaps much more..), which although true, is not nearly as large of a loss as the opportunity cost incurred by investing in nothing. Many will provide APY estimates for investing in common market indexes between 6% and 9%, but examining as much as the last few decades (or even just the last decade) will show significantly greater numbers. $SPY has returned over 10% per year since its inception 29 years ago, and around 16.5% per year for the last decade (the last 3 years are even more impressive at 26% each on average!). I do not attempt to claim these are indicative of future results, or that we should be promising anyone these numbers, but it does seem to be unfair to weigh our expected market growth by including past decades that go so far back that we lacked not only much of our modern monetary policy knowledge, but also inventions as basic as the Internet itself.

If casual returns of 10.5% per year were not enough to motivate oneself, I often like converting these APYs to the period of a decade – in which case 10.5% corresponds to a 171% gain (1.105^10), 16.5% APY to a 360% gain, and 26% APY to a >900% gain. We could, of course, make these numbers even more grandiose by telling someone what returns they may expect by holding an investment for 20 or 50 years, but I find a decade to be a relative sweet spot, perhaps because people have an easier time imagining themselves a decade in the future rather than several.

I have heard many reasons for why people choose not to invest in ETFs (or anything similar such as individual stocks), from the reasonable “I am purchasing a house in a few months and now is not the time to take on any risk”, to the questionable “I am waiting for things to cool down a bit and I am a bit worried about some things in the near future”, to the absurd “I do not trust wall street or bankers, sorry” (and indeed, much can be said about how poorly we educate our citizens in the US about basic personal finance, which unfortunately involves much more than just basic investing). I am not going to spend many words attempting to convince someone that holding cash long-term (a year or more) is sub-optimal, because it seems obvious enough to me that it’s considered outside the scope of this post.

What margin is and isn’t

Most young professionals are now fully aware of what index funds are, and often have some simple strategies for investing in them. While it’s not my job to decide the risk tolerance of others, I do think it’s nice to at least be aware of some options that can generate significantly higher long-term returns than these traditional index ETFs. This is not investment advice, and regardless of if it was, I would not want to be responsible for someone else’s choices should things turn south.

The primary product I’d like to mention is that of leveraged ETFs. Many will initially recoil upon hearing the term ‘leverage’ mentioned in the context of personal finance, because they know that it’s scary and can be involved in situations where someone loses their entire principle (that is, 100% of their portfolio). It’s for this reason that I want to start with mentioning the difference between buying stocks on margin and purchasing a product which itself uses margin.

Buying stocks on margin is generally considered to be risky, because you are buying more than you can afford with your own money, effectively taking a loan from your broker in order to afford additional shares. Generally leverage of up to 4x is attainable with popular large-cap stocks on most US brokers, although there’s many exceptions to this. Although buying stocks on margin is not something I would generally suggest for many reasons, it does have a lot of uses, and it can be much less intimidating and dangerous than many may guess. Tools to analyze, manage, and properly limit one’s risk to a comfortable level are readily available, and rates for margin loans can be as low as 1% or under (IBKR is generally the golden standard for the lowest margin rates for regular retail investors, but some other platforms do offer better interfaces, tools, or additional products, and will also be able to negotiate rates with you should you have sufficient capital).

The obvious downside to margin is that you can lose much more of your investment. Theoretically, if you bought a stock with 4X leverage and it then declines by 25%, you would find yourself broke. In practice, you will get liquidated by your broker before this happens, unless the 25% decline happens instantaneously and they do not have enough time to sell your securities on your behalf (If you have heard the term margin call before, that is what happens when you do not have enough capital to maintain your leverage, generally after whatever you own performs very poorly. You can either deposit more money to get back to your maintenance margin, sell some of the products you own via leverage, or let your counterparty liquidate them for you). I am not going to get into the different types of margin or ideal scenarios for using it (of which there are many – remember, this is a loan with an interest rate of only 1%!) in this post, but rather have included this information to help it contrast with what a leveraged ETF is.

Leveraged ETFs

A leveraged ETF is not the same as buying stocks on margin. It is similar in that it is a higher-risk investment that easily allows one to lose or gain much more than usual, but it is different in that you are not taking out a loan explicitly nor implicitly, are not in debt, and therefore cannot be margin called, liquidated, or otherwise lose your shares via any means except via deciding to sell them yourself (this doesn’t mean they can’t still decrease in value by an arbitrary amount of anything less than 100%, however).

A leveraged ETF functions similarly to a regular ETF – it is a security that you can purchase, in which the work of managing your portfolio is abstracted away from you, and instead done by the issuer of the ETF. Instead of buying shares in 500 companies and managing their proportions yourself, you can simply purchase a share of $SPY and forget about it. In exchange for this convenience, you are charged a fee of 0.094% per year (this is often listed by brokers and compiled by ETF websites, but the original source is in the prospectus for the given security). The goal of an ETF is to track its underlying index – if the S&P 500 index is down by 1% in a given day, $SPY should be down close to that amount as well. A leveraged ETF attempts to perform the same function, however it introduces a linear multiplier which multiplies the intended gains and losses. In the US you will generally only find products that offer 2x or 3x leverage due to SEC regulations (3x products are often grandfathered in, as a 2020 update from the SEC suggests a general cap of 200% leverage via derivatives being allowed), although this introduces much more than enough additional risk and volatility for most investors’ appetites (should one want more leverage, they can create additional artificial leverage through the use of options, but that is also outside the scope of this post. Also, gambling is bad, Just Say Neigh!)

Leveraged ETFs are re-balanced daily, and thus intend only to match the performance of their underlying index (multiplied by 2 or 3) for a given day. If the S&P 500 index goes up 1.5% in a day, then a 2X leveraged ETF for it should return close to 3% that day. Due to their targets being daily, some investors often misinterpret this as being equivalent to matching returns on longer periods, although this is not the case. This has been misunderstood enough that the SEC has an alert attempting to inform investors of this, providing some historical examples of leveraged ETFs declining in value during longer periods, during which the underlying index performed positively. This is generally referred to as ‘volatility drag’, and is one of the largest reasons for which many discourage investors from purchasing these products. Much has been written about it, so I will just offer a very short summary: during periods of volatility, leveraged ETFs will perform worse than one would expect at first glance. To give a simple example as to why, imagine that portfolio A returns 5% on day one and then loses 5% on day two. If you started with $100, you will end up with $99.75 ($100 * 1.05 * 0.95). If portfolio B multiplied these daily fluctuations by 3X and returned 15% on day one and -15% on day two, $100 would turn into $97.75 ($100 * 1.15 * 0.85). As you can imagine, if we iterated over these scenarios many times, portfolio B would start to perform terribly in comparison to the portfolio with less leverage.

Volatility drag, aptly-named, is bad during periods of volatility, but it’s particularly bad when there’s not enough underlying momentum in the upward direction to counteract it during longer periods. During a market that is performing even moderately well, generally the greater returns provided by leveraged products don’t just return more than is lost due to volatility drag, but return so much more that being fearful of the concept can be actively harmful (this is likely a controversial opinion in many areas, for what it’s worth – but many people become scared of an investment that could feasibly return 1,000% over a period because of a potential loss of 10% or 50%, even if it’s clearly a very high expected value. In some cases this may be rational due to the diminishing returns of utility provided by additional capital (money may buy a little happiness, but this caps out pretty quickly, and having no money is definitely much worse than having just a little!), but it is well-known that humans are far too risk-averse as a general principle regardless).

To provide some examples, I will mention some leveraged ETFs alongside the returns that they have provided historically. As usual, past performance is not an indication of future results!

$SPUU, a 2X-daily-leveraged ETF that tracks the S&P 500 index, has returned an average of 32% annually for the last 5 years, and 27% annually since inception. $SPXL, a 3X-daily-leveraged ETF that also tracks the S&P 500, has returned an average of 41% annually for the last ten years. Those of you used to performing basic calculations on compounding annual rates will quickly realize how absolutely insane these numbers are – 41% returns compounding for a decade comes out to a return of +3,000%! This is something that is possible, and that many investors have actually attained, providing they didn’t sell during draw-downs (this is not the same as it being guaranteed, or even probable, however).

If past performance is not a promise of future performance, then why is it being mentioned so saliently here? Because although strong performance is not guaranteed, this helps to illustrate the potential of what happens with leveraged ETFs when things go really well, which we can reasonably say has been the case since 2010 to 2022. Because things are not guaranteed to go well, putting 100% of your net worth into these leveraged products is reckless and is very likely a bad idea. However, just as some people like to have hedges just in case things go south, I think it’s important to have some minor positions in place just in case the opposite occurs: If we get lucky and the next 10 years go as well as the last, it is quite possible to attain a 20x, 30x, or greater return on your investment. If you get unlucky, you may lose some or most of your investment, but no more than 100% of it, so the risk to reward is very strongly in your favor (yes, the math is much more complicated than this, but the result holds in more nuanced conditions regardless). In the next section I will go over a few basic common questions about leveraged ETFs, as well as mentioning more of the negatives.

Leveraged ETFs exist for most popular stock indexes, including sector indexes. For example, $SOXL is a 3X-leveraged ETF based upon the ICE Semiconductor Index, which primarily consists of companies related to semiconductor manufacturing. As it is my personal opinion that we are going to tile the world several times over with semiconductors (or something equivalent) in the coming decades, this is a product that I’m a fan of personally, even if it is very high-risk. For some listings of leveraged ETF products, check out out these pages from Direxion and Proshares

Responses to common concerns about leveraged ETFs

Aren’t leveraged ETFs not intended to be held for longer than a day?

This is mentioned in many locations, but it functions primarily for the purposes of legal liability and investor protection. There is nothing wrong with holding these products for longer periods, as long as one is properly educated about them. This is the type of warning where those that it does not apply to will know they can ignore it. There are other similarly-accessible products that are much worse ideas to hold for longer durations, for example inverse-leveraged ETFs, which return the opposite of what the underlying index returns, and thus trend towards zero over the long-run (for an example, $SPXS has returned -47.22% since inception, which leads to over a 99% loss after a decade. If you’re curious why inverse ETFs exists, they are primarily for short-term speculation and various types of hedging).

Aren’t leveraged ETFs subject to volatility drag, and thus a bad idea to hold long-term?

As mentioned above, volatility drag is an important thing to be educated about and aware of. However, if markets actually perform well, the potential gains from leveraged ETFs significantly outweigh (often by more than an order of magnitude) losses due to volatility drag. Regardless, it is worth noting that as many leveraged ETFs are recent financial products, there is an inherent cherry-picking present in the data used to show how well they perform, as the previous 5-20 years have been favorable financially for most US sectors.

Don’t leveraged ETFs have much higher management fees than most normal ETFs?

This is true, and is also something to note. As with the above two examples, $SPUU’s gross expense ratio is 0.88%, and $SPXL’s is 1.03%. Similarly to volatility drag, while it’s important to be aware of these expenses as they do add up and eat into long-term profits, if the market performs well, you will make so much that you will not even notice it.

I don’t want to get margin called, gamble with money that is not mine, or be in debt

Luckily none of these things occur when purchasing leveraged ETFs. You can still lose almost all of your money, but you cannot go into debt or have your shares taken away from you (unless you are engaged in other things that may cause this).

Leveraged ETFs have draw-downs that are far too high for the risk tolerance of every day people

I would say this is completely true. If we take a fund like $SPXL and look at what happened during the covid crash, it crashed from $76 to $18 in a single month, or a decline of around 77%. Apart from this being bad financially, drawdowns this large often cause significant emotional distress to investors and can easily cause them to make poor choices and panic-sell at market bottoms. While $SPXL may have returned back to $76 in less than a year (and then somehow doubled in the year after that..), this will obviously not always be the case. It’s quite possible for drawdowns in some leveraged ETFs to reach 90% or more, even if very rare.

This is gambling

All investing is gambling, mathematically speaking. The absence of investing is also gambling due to opportunity cost – if you hold USD, you are literally betting for it and the US to do well! While it’s true that this is more like gambling than other financial products in the views of many, it should not be compared to acts such as buying a lottery ticket or going to a casino, where there is a known large house edge against you, with the objects in question having been specifically constructed in order to gain the upper hand over you.

Markets exists everywhere and will not go away any time soon, so there is no option of ‘not playing’ the game, as unfortunate as that may be for some of us. The only question is what one’s risk tolerance and personal choices are, not whether they exist or not, because they are forced into existence by our environment. While it may be easy to lose a lot of money on leveraged ETFs, it is nowhere near as bad as buying short-term out-of-the-money options, binary options, 100x leveraged cryptocurrency swaps, 250x forex trades, writing uncovered cryptocurrency options, and many other ‘fun’ products that exist and are often traded by young males addicted to gambling.

How much of my money should I invest into leveraged ETFs?

I have no clue; the right answer for you, dear reader, could very well be 0%, 100% or anywhere in between, but I am not the one that can decide for you. I can say that it is worth your time to learn a lot about how personal finance works however, regardless of your risk tolerance or intentions.

Something something trading leveraged-ETFs or other things

Although I am not in the business of telling people what to do financially, I do enjoy telling people things I think that they should not do, and one of those is ‘trading’. The short version of my advice on this matter is that you should be buying and selling things as infrequently as possible, and you should avoid things like ‘day trading’ like the plague. If you find yourself constantly checking prices, you are likely over-leveraged. I have watched too many bad things happen to too many amazing people, many of them very smart, and most of them young males, and I want to do what I can to cause gambling addictions and casual day-trading to happen less. The humor of places like r/wallstreetbets may be quixotically funny at times and comically sardonic at others, but behind all of the fun people are having with memes about cryptocurrencies and options on Reddit and Twitter, lay thousands of people who have lost their life savings, many of which who end up taking their own lives or losing decades of accumulated capital. Markets are not a game, and if they find a way to eat you alive, they will, as they have become exceedingly efficient at it in the recent few decades.

Further Reading

• Dissecting Leveraged ETF Returns
• HEDGEFUNDIE’s excellent adventure [risk parity strategy using 3x leveraged ETFs]
• Leveraged ETF on Investopedia

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