ETFs have become a popular investing instrument for retail investors, but leveraged ETFs come with dangers for investors who don't know how they work.
A leveraged ETF doesn't follow the long-term performance of an underlying index; it is built to follow the DAILY performance of an underlying index. This means that when you do the math, the leveraged ETF will eventually deteriorate in value as long as the underlying index moves up and down over time.
How come? Take a look at the graph below of two reference indexes and two leveraged ETFs that provide leveraged returns of the referenced index.
The concept of leveraged ETFs may seem very straightforward at first glance. However, this is actually a very tricky trade because leveraged ETFs “rebalance” daily. In other words, all price movements are calculated on a percentage basis for that day and that day only. The next day you start all over from scratch.
Here’s an example of how daily rebalancing causes something called “beta slippage”, which can wreak havoc with your expected profit and loss calculations and leave you with worse-than-expected returns.
Imagine you pay $100 for one share of a 2x leveraged ETF based on an index that’s currently at 10,000. That same day, the index goes up 10% and closes at 11,000. As a result, your share will increase 20% to $120. So far so good, right?
Here’s the catch: now imagine you hold onto the leveraged ETF overnight, and continue to hold it all through the next day’s trading session. If the index goes back down from 11,000 to 10,000, that’s a decrease of 9.09%, so your 2x leveraged ETF will go down 18.18% for the day.
That probably doesn’t sound so bad, since the price was up 20% the previous day. However, 18.18% of $120 is $21.82, so your share price will end up at $98.18. Even though the index wound up exactly where it started, your trade is down 1.82% because you held onto it for multiple trading sessions.
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