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While the performance of leveraged exchange-traded funds over recent market rallies might be dazzling, investors needn’t look far for horror stories. A litany of leveraged ETFs closed in 2020 as they amplified extreme market losses and wiped themselves out. Those that managed to stay open through March 2020 had the pleasure of crashing and burning again in 2022 after eye-popping gains in 2021.
What makes these ETFs such a bad investment choice? At the core of their woes, these funds suffer from a phenomenon called volatility drag. Volatility drag hurts all investments, but the leveraged nature of these ETFs amplifies the problem and makes their losses exponentially harder to beat.
Leverage’s Bad Reputation
Volatility drag comes from fluctuations in the day-to-day returns of a leveraged ETF’s underlying index. It causes actual portfolio growth (geometric return) to trail the arithmetic return. Greater volatility leads to a larger gap between the two. In other words, a 2-times leveraged ETF that resets its leverage each day will not always give you twice the index returns if held for more than a day. In fact, most leveraged funds’ prospectuses write at length about this risk using hypothetical returns.
Consider a daily 2-times leveraged ETF that tracks the S&P 500. If the index loses 10% today and ends up at $90, it must climb by 11.1% tomorrow to get back to where it started. In this scenario, the ETF investor would lose 20% (ending up at $80) and gain twice the index returns at 22.2%, netting only $98. Mathematically, a loss always requires a subsequently higher gain to break even. Larger losses increase the offsetting gains exponentially.
This hypothetical ETF would deliver twice the market’s return only when the market consistently rises. If the index had gained a meager but consistent 0.5% in each of those two days, the ETF would’ve delivered a 2.0% gain—indeed, twice the index’s returns. But markets are rarely so consistent. Instead, markets tend to alternate through periods of gains and losses instead of climbing linearly, especially over shorter periods when noise is paramount.
This is not to say that these ETFs are doomed to fail. They can succeed when the index’s gains are substantial enough to overcome the odds stacked against them. During the recent explosive rallies where the market seemed to only go up, some of these funds pocketed triple-digit annual gains and outpaced the already-impressive returns on their indexes.
But watch out for losses. Exhibit 1 displays the growth of the oldest daily 2-times leveraged S&P 500 fund that’s still around, the ProFunds UltraBull ULPIX, against the S&P 500. The leveraged fund eventually came out on top, but it took an arduous route to get there. It initially got crushed during the dot-com bubble, and then 2008’s global financial crisis dealt another blow. It started beating its benchmark only in 2021, though it took another detour and fell behind once more in 2022.
This fund got off to a rough start with some of the worst possible timing luck. But it’s always difficult to predict when the next major drawdown might happen. Amplifying these large losses can mean a long journey back up. Even if an investor has a long enough horizon, they’re still incurring a major opportunity cost. And the higher the leverage, the longer it will take a fund to recover.
It’s worth pointing out that these funds’ rebalancing cadence adds to their issues. As their underlying index appreciates, the managers must buy more derivatives to increase their notional exposure and maintain their stated leverage level. Likewise, they must sell derivatives when the index loses. That means deploying money into an expensive market and selling in an already-falling environment—buying high and selling low. This daily rebalancing means recognizing every gain or loss by the index, which increases the volatility of the return stream. Rebalancing every month, rather than every day, sounds like a potential solution. But leveraged ETFs with a monthly reset schedule seem to be doing just as poorly, so they don’t really solve the problem.
Costs also eat into returns. Transaction costs run high with the ETF’s frequent rebalancing, and these ETFs typically come with high fees.
Can Leverage Be a Friend?
While daily leveraged ETFs can seem like land mines, leverage itself isn’t necessarily a bad idea. At its core, leverage is simply investing a higher notional value than your actual dollar investment. Used appropriately, it can be an efficient way to increase exposure to financial assets, such as a mortgage.
The ETFs discussed above sought to double or triple the return of a single index. A better strategy would diversify that notional exposure across different assets with low or negative correlations. This should reduce the underlying portfolio’s volatility and the dreaded volatility drag.
Exhibit 2 displays the since-inception performance of WisdomTree U.S. Efficient Core ETF NTSX against the S&P 500 and a classic 60/40 portfolio. WisdomTree U.S. Efficient Core ETF uses Treasury futures to leverage typical balanced exposure up to a 90% stock/60% bond portfolio. The 60/40 portfolio allocates 60% to the S&P 500 and 40% to the Bloomberg US Aggregate Bond Index.
The fund’s track record is short, but it spanned a decent number of market environments to demonstrate patterns in its performance. The low correlation between stocks and bonds helped the fund outperform the S&P 500 during the covid shock in 2020. WisdomTree U.S. Efficient Core ETF had less ground to reclaim than the S&P 500 coming out of March 2020, and it held on to its edge through 2021, despite lower exposure to stocks during an exuberant market. Its higher exposure to Treasuries and their minimal credit risk helped it hang with the unleveraged 60/40 portfolio in early 2020, and then WisdomTree U.S. Efficient Core ETF’s higher equity exposure helped it easily outpace the 60/40 portfolio over the ensuing 20 months.
Unfortunately, the fund fell into the same trap as other leveraged strategies when stocks and bonds moved together in 2022. It trailed the S&P 500 during the 2022 meltdown, erasing much of its earlier gains. The fund still hasn’t regained its edge over the index, and stock-bond correlations remain elevated above historical norms.
Nonetheless, the argument for using leverage on a diversified portfolio still stands. WisdomTree U.S. Efficient Core ETF’s plight in 2022 and beyond was due to converging poor performance between stocks and bonds in its portfolio. The fund performed better, and as typically expected, when Treasuries properly hedged its stock exposure during 2020’s drawdown. Additionally, WisdomTree U.S. Efficient Core ETF kept closer pace to an all-stock portfolio, thanks to its higher notional exposure to stocks, which solves the typical cause of underperformance for balanced portfolios.
While it’s tricky to decide which (combination of) diversifying asset classes will hold up well in a full market cycle, leverage remains a useful tool for the endeavor. Any individual components of the portfolio will still suffer from volatility drag, as they’re a leveraged version of their underlying indexes. But taken together, the diversified return stream can lower the barrier for outperformance.
This article first appeared in the September 2024 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor by visiting this website.
The author or authors do own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
Correction: This article originally appeared with the same exhibit appearing twice. It has been corrected.
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