4 must-know drawbacks to investing in leveraged ETFs

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Four drawbacks to investing in leveraged ETFs

Leveraged ETFs are inherently riskier than traditional ETFs, as they use borrowings and complex derivatives to generate a return in multiples of an benchmark index. The ProShares Ultra S&P500 (SSO) seeks to generate twice the daily returns of the S&P500 (VOO) before fees and expenses. The fund has invested in Apple (AAPL) and Microsoft (MSFT). However, a large chunk of its holdings are in the form of swap agreements with financial institutions. For example, the fund entered into swap agreement on the SPDR S&P500 ETF (SPY) with Deutsche Bank under which the fund received twice the return on SPY on a given day.

impact of leverage

Due to structure of leveraged ETFs, they’re prone to the following drawbacks.

  1. Risks associated with daily compounding
  2. Risks associated with derivatives
  3. Higher costs
  4. Less tax efficiency

1. Risks associated with leverage and daily compounding

As we explained earlier in this series, it’s not really a simple “1+1=2″ when it comes to calculating ETF returns over a period greater than one day.

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As you can see in the above table, the ETF has given exactly twice the return on the benchmark for each of the two days. The benchmark index has increased 10% on Day 1, while the ETF has given 20% returns on the same day. Even on Day 2, the ETF fell 18.18%—exactly twice the fall in the benchmark index.

However, while the index returned to the opening price after the fall, the ETF has in fact lost 1.82% over the two days.

This phenomenon may magnify in periods of heightened uncertainty, when gains follow losses.

2. Risks associated with derivatives

Leveraged ETFs make extensive use of financial derivatives to amplify returns. Derivatives are inherently riskier than direct investment due to the leverage they offer. In addition to the counterparty risk that all ETFs face, leveraged funds are prone to derivative counterparty risks. Under certain conditions, the fund may get a margin call from the counterparty if the underlying index drops significantly, posing liquidity issues for fund managers.

3. Higher costs

Leveraged ETFs incur transaction costs while resetting their portfolios. Just like other actively managed ETFs, they’re structurally more expensive. The ProShares Ultra S&P500 (SSO) has an expense ratio of 0.90% compared to 0.09% for the SPDR S&P500 ETF (SPY).

4. Less tax efficiency

As per an SEC release, leveraged ETFs may be less tax-efficient. Due to the daily reset clause, investors may record large short-term capital gains that may not be offset by a loss.

Due to the risks associated with leveraged ETFs, they may not be suitable for all investors. For our advice on investing in leveraged ETFs, read on to the next part of this series.

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