Should You Use Leveraged ETFs Over The Long Haul?

If there’s one ETF product on the market that continues to generate huge amounts of controversy, it has to be leveraged ETFs. These funds seek to amplify your bets — sometimes as much as 3x — in everything from broad stock indexes and sectors to commodities and bonds. By using various swaps, futures and other derivatives, the ETFs hope to provide that extra “juice” for a single day. According to our database, there are now 209 Leveraged ETFs in the market with new launches happening all the time.

There have been plenty of warnings from advisors, market pundits and product sponsors that these funds are designed for short term trading purposes only.

But are there instances where a leverage fund could work for longer periods? And if so, is it worth adding a dash of these ETFs to your portfolio?

Structured, leveraged ETFs provide an amplified return for a single day. Just one. Then they reset and provide that same amplified return for the next day. That’s the biggest misconception many investors have about leverage ETFs. They assume that if the index is up 8% for the year, then their 2x leveraged ETF will be up 16%.

That is not the case.

The problem with leveraged ETFs and why they get a bad rep has to do with a concept called decay. It’s this decay that cause them to receive such ire from many market pundits. And it’s an easy concept to illustrate.

If an index rises 5% and goes from 100 to 105, then a 2x leveraged ETF would jump to 110. That’s all well and good, and you’ve made some extra cash for doing essentially nothing. The issue is when the index then falls.

If the next day, the index drops back down from 105 to 100 — a 4.76% loss — the leverage ETF begins to show its decay problem. Twice the drop (9.52%) would send the 110 leveraged ETF down to around 99.5. You now need even bigger positive gains to break even on your leveraged ETF investment.

This decay issue is how some leveraged ETFs can actually finish with losses for the year, when their parent indexes finish with positive gains. For example, the Direxion Daily S&P 500 Bull 3X Shares (SPXL B+) managed to lose 16% during 2011, even though its benchmark — the S&P 500 — ended at around the same price point as in the beginning of the year. The decay throughout the year caused the leveraged ETF to dip negative and never regain a positive position.

And yet, sometimes over long periods, leveraged ETFs do work. The (SPXL B+) managed to return roughly 118% in 2013, while the S&P 500 only gained 32%.

The reason for the outperformance has to do with low volatility and trending higher markets. When the market is weathering a storm and jumps around more, you have more of the decay effect. Volatility kills leveraged ETFs. The swings in leveraged ETFs will be two to three times that of a parent index. The real issue is trying to guess how volatile the markets will be as well as the overall trending direction. Which is why many advisors and market pundits have suggested that leveraged ETFs are bad for the long term.

But Wall Street’s definition of long term is actually quite short.

Long term in Wall Street speak could actually mean 6 months. What if you actually hold one of these leveraged ETFs in a retirement portfolio for 5 years or so? Well, the results might not be that bad.

Over the last five years, the ProShares UltraPro S&P 500 (UPRO A) — which is a 3x leverage ETF — is up 316%. The regular S&P 500 is only up 69%. Similarly, the double leveraged ProShares Ultra S&P 500 (SSO A) was up 185%.

Certainly, if you were to zoom in on any point on that chart, you can see plenty of decay and peaks/valleys for the leveraged ETFs. But just like how time soothes regular losses in a portfolio, it seems to smooth out those hiccups for leveraged ETFs if the market is trending up.

So should you sell your bread-n-butter index ETFs and plow all your savings into leveraged ETFs? That’s a big fat no. That decay problem is real and the jumpiness of these funds can be a bit hard for investors to swallow. Leveraged ETFs are risky and if you need to pull out your investments for retirement or other purposes at downswings, your losses can be staggering. Having all of your portfolio in something like ProShares UltraPro S&P500 (UPRO A), a 3x leveraged ETF, could be a death sentence.

And yet, if you have the timeline, adding a dash of leveraged ETFs (provided you still had a balanced portfolio) may not be such a bad idea. It could provide just enough “juice” to improve your returns over the long term if the market is trending up with low volatility. Just don’t overexpose yourself to these ETFs.