Leveraged ETFs Are Fundamentally Flawed

Source: Yahoo Finance

Note: ERX (Light Green): Direxion Daily Energy Bull 2X Shares; ERY (Dark Green): Direxion Daily Energy Bear 2X Shares; XLE (Blue): Energy Select Sector SPDR

Note: Time series of security returns between 1/1/2009– 7/1/2024

Energy stocks, as measured by the XLE, increased in value by +228% between 2009 and 2024. Armed with this fact, and a time machine, one may be tempted to travel back to 2009 and buy the Direxion Daily Energy Bull 2X Shares ETF (ERX), which is meant to replicate the XLE, but to be double as potent. One might think to themselves, if the XLE is up +228%, then this index should be up ~456% (228% * 2 = 456%), right? 

One uses the time machine, packs a suitcase with $100K, buys ERX, and travels back to the present. Upon arrival in 2024, one is shocked to see that not only did the capital not grow, but rather it mysteriously lost -74% of its value and is now only worth $26,000!  What happened?   

How did the 2x bull leveraged ETFs (ERX) lose 74% when the underlying index was up 228%?

Leveraged ETFs are fundamentally flawed.  

Leveraged ETFs are securities that use financial derivatives (i.e., leverage) to magnify the returns of an underlying investment. Mechanically, many leveraged ETFs are forced to rebalance at the end of each trading day to ensure they remain within their target leverage ratio – most commonly, double- or triple-leverage (illustrative example in the Appendix). This results in volatile price action for leveraged ETFs as its returns are influenced by: the direction and volatility of the underlying index.

In other words, knowing if the underlying investment went up or down over a period, does not tell you anything about how much your leveraged ETF will be up or down. You need to know the volatility of the underlying investment, as well. 

And the greater the volatility, the worse leveraged ETFs tend to do.

When Do Leveraged ETFs Work?

There are situations where leveraged ETFs can be a profitable investment, and outperform the underlying investment, primarily in instances when the trend in the underlying investment return is greater than its volatility. 

Since 2009, the iShares Russell 2000 ETF (IWM) generated a cumulative total return of +464%.

During this same time period, the Direxion Small Cap Bull 3x (TNA) generated a cumulative total return of +570%. This is an example of the leveraged ETF outperforming the underlying index. So the leveraged ETF “worked” in this example, though it introduced 3x the volatility and only ~1.2x the returns (+570% / +464%).  We would not be surprised if TNA substantially underperformed the IWM over the next 15 years. 

Source: Yahoo Finance

Note: IWM (Light Green): iShares Russell 2000 ETF; TNA (Blue): Direxion Daily Small Cap Bull 3X Shares; TZA (Dark Green): Direxion Daily Small Cap Bear 3X Shares  

Note: Time series of security returns between 12/1/2008– 7/1/2024

The above chart demonstrates the cumulative total returns from investing in ETFs that track the Russell 2000 index from 2009 – present (July 1, 2024). 

• The blue line shows the result of investing in the Russell 2000 ETF (IWM), generating a cumulative return of +464%. This security tracks the performance of the Russell 2000 index, measuring the small-cap sector of the U.S. equity market.

• The light green line represents the Direxion Small Cap 3x Bull (TNA), generating a cumulative return of +570%. This security aims to reproduce 300% of the daily returns of the Russell 2000.

•  Lastly, the dark green line represents the Direxion Small Cap 3x Bear (TZA), generating a cumulative return of -100% (i.e., complete loss of capital). This security aims to reproduce daily returns that are 300% of the inverse of the Russell 2000.

Concluding Thoughts

Leveraged ETFs are fundamentally flawed and are not good securities for long term investors.  Their returns are based upon the interplay between price direction and volatility.

We advise our clients to avoid leveraged ETFs. 

Example: The Impact of Volatility on Leveraged ETF Returns

Many leveraged ETFs are destined for value erosion over time – with the magnitude of erosion depending on the interplay between trend and volatility.  

Operationally, at the close of each trading day, the target leverage ratio needs to be maintained. As such, the ETF is forced to ‘buy’ at the close of an up day or ‘sell’ at the close of a down day. Buying high, selling low. 

In the example below, the equity value of a traditional ETF across the 5-day trading window generated a return of +2%, meanwhile, a triple-leveraged ETF generated a return of -7%.

 This is a function of the ETF being forced to ‘buy’ or ‘sell’ to maintain the leverage ratio (3x in this case) at the end of each trading day.

 The rebalancing activity of the leverage ETFs is what causes the divergence of returns over longer periods of time. 

Traditional (Non-Leveraged) ETF

Source: Ahara Advisors

Note: The above analysis is an illustrative example and not related to any specific asset or index.

Triple Leveraged ETF – Must maintain 3x Leverage Ratio

Source: Ahara Advisors

Note: The above analysis is an illustrative example and not related to any specific asset or index.