The Dangers of Leveraged ETF's

In the past decade ETF's have become popular investment vehicles for traders and investors alike. Leveraged ETFs are a type of ETF that track a benchmark or underlying index and use leverage to maximize the performance of the underlying benchmark (typically an index or commodity). They are offered in the form of 2x (ultra) or 3x (pro) leverage and can be either bullish meaning long the underlying asset or inverse, meaning short the underlying asset. For example a popular 3x leveraged crude oil ETF is UWTI. If the price of crude oil goes up 2% the price of UWTI should go up 6%. Some other popular leveraged ETF's include:

• SSO - 2x Ultra S&P500
• AGQ - 2x Ultra Silver
• NUGT - 3x Daily Gold Miners Bull Shares
• DWTI -  3x Inverse Crude Oil
• YANG - 3x Daily China Bear Shares

These instruments have quickly rose to popularity and have seen huge inflows amid the recent volatility in commodities. Despite they're growing popularity, few retail investors and traders truly understand the dangers associated with these complex products. This lack of understanding is concerning considering their growing popularity. CEO of BlackRock, Larry Fink has even publicly commented on the systemic risk they pose to our financial system by saying "leveraged exchange-traded funds contain structural problems that could "blow up" the whole industry one day." This is an alarming statement seeing as Fink's company BlackRock is the largest ETF provider!

Leveraged ETFs allure retail traders with huge daily price swings. Especially inexperienced traders who are looking for investments with big returns to help grow their portfolios. In addition to offering big returns they also offer traders leverage without needing a margin account. It's normal to see these ETF's move 5% or more in a day. Wild daily price swings like these have traders licking their chops and many impulsively jump right into them without fully understanding how they work.

One of the biggest mistakes people make with leveraged ETFs is buying and holding them as long-term investments rather than using them as short term trading vehicles. The intended purpose of these products is to take advantage of daily price movements. Therefore, the appropriate way to use leveraged ETFs is to day trade them. The reason they pose a greater risk when holding for a longer time frame is because every night these funds go through rebalancing where the fund manager has to re-allocate the funds assets to accurately track the underlying index or commodity.

Rebalancing every night causes price decay known as beta slippage. The longer the time they are held for the greater the potential for slippage. To learn more about leveraged ETFs and the math behind slippage check out this video. 

Another quality of leveraged ETFs that make them potentially dangerous is that they are often difficult to analyze. Many retail traders don't realize that typical technical analysis and charting doesn't work well on leveraged ETF charts due to the daily rebalancing. Instead you must analyze the chart of the underlying asset.
Leveraged ETFs can be useful for day traders looking to leverage their position without using margin however things like rebalancing are things people need to consider before using these products. In addition, management fees and slippage are two main characteristics of leveraged ETFs that should make them unattractive to long-term investors. 

​If you do decide to trade these products, it's imperative that you have a thorough understanding of some of the risks that are associated before using them.