Leveraged exchange traded funds have helped investors juice market returns. However, people should not blindly add these types of products into a portfolio without fully understanding how the investments work.
These geared products try to generate the multiple returns of a given market by taking on leverage through derivatives instruments, writes Dan Caplinger for The Motley Fool.
However, most leveraged ETFs are designed to produce double or triple the performance of the underlying market on a daily basis. Consequently, when investors look at the long-term performance of a typical leveraged ETF, people may notice that the fund may not perfectly reflect their intended strategies.
For example, the ProShares Ultra S&P 500 ETF (NYSEArca: SSO), which attempts to deliver twice the daily returns of the S&P 500 index, has more or less closely followed its intended 2x multiplier over the shorter term. SSO rose 8.8% over the past three months and increased 24.6% year-to-date, whereas the S&P 500 was up 4.6% over the past three months and 13.0% so far this year.
A strong bull market without long interruptions and relative lack of volatility helped maintain positive gains in the leveraged ETF. Since the ETFs rebalance on a daily basis, the compounding effect benefits leveraged ETFs in a upward-trending market.
“In an upward-trending market, compounding can result in longer-term returns that are greater than the sum of the individual daily returns,” according to ProShares. “In a downward-trending market, compounding can also result in longer-term returns that are less negative than the sum of the individual daily returns.”
However, in times of increased volatility, leveraged ETF returns can fall behindtheir intended 2x or 3x strategies. For instance, when including the period leading up to the financial crisis and the financial meltdown, SSO rose 63.8% since 2007 while the S&P 500 gained 70.6%.
“In a volatile market, compounding can result in longer-term returns that are less than the sum of the individual daily returns,” according to ProShares.
Additionally, leveraged ETFs tend to be more expensive than the average index-based ETFs, which could also eat away at returns over the long run. The average expense ratio for leveraged ETFs is 0.92%, whereas the non-leveraged ETFs have an average expense ratio of 0.54%, according to XTF data.
For more information on geared products, visit our leveraged ETFs category.
Max Chen contributed to this article.